Isa misers starting to raise rates for savers

RETURNS on tax-free Individual Savings Accounts, or Isas, are at their highest for more than two years, but savers who rely on the income from their nest eggs to live may still be disappointed.

This year's Isa season is now off the starting blocks, with companies fighting hard for your money before April's deadline. If you don't use this year's tax-free allowance before the end of the tax year, you lose it. But with typical returns of below 3 per cent on cash Isas, investors will be weighing their options carefully.

Each tax year, investors can shelter up to 10,200 from tax in an Isa. Getting down to the detail is a bit more complex. You can only invest 5,100 in a cash Isa, and the rest must be held in shares or other equity investments. These limits are set to rise in line with inflation from April.

Yet research from Royal Bank of Scotland last week revealed that many savers remain confused about Isas and the tax benefits of putting money into these accounts.

Since the start of the current tax year, in April 2010, only 16 per cent of adults have opened a cash Isa, for example. Of those who haven't, 39 per cent say the reason for this is because they require instant access to their funds.

Phil Sheehy, head of savings at RBS, explains: "It's clear that many remain confused or misinformed about Isas. Not having the right information contributes to poor savings habits and may lead to longer-term detrimental effects to the would-be saver's finances."

Anyone with money lying around in bank or building society accounts should have a cash Isa to protect their interest from tax, otherwise basic rate taxpayers lose 20 per cent of the return, and higher earners 40 per cent. Cash Isas operate in the same way as ordinary savings accounts.

Ignorance holds many back. For example, the excuse given to the RBS researchers about needing instant access is a red herring. Isa cash can be withdrawn, unless the specific terms of the account block withdrawals, in the same way as any fixed rate or penalty account.

However, with rates so low, the urgency to save 20 per cent of not very much, is clearly underwhelming some.

Higher returns may be available from equity Isas, but these come with greater risk. If you cannot afford to lose any money, or sit tight through the ups and downs of stock markets, these will not be for you.

Furthermore, equity Isas offer greater shelter from tax for higher rate taxpayers, with more limited protection for those who pay basic rate tax. The Isa wrapper shelters the profits made from rising share prices from capital gains tax, which will have proved valuable for big investors given that share prices, as measured by the value to the UK's top 100 companies, have risen by a third over the last two tax years.

However, when it comes to the income from investments, known as dividends, there is no obvious protection from basic rate tax. Higher rate taxpayers do enjoy some protection against an additional 25 per cent tax they would have to pay on dividends outside the Isa wrapper.

The main benefit therefore is the protection against capital gains tax. However, it is important to remember that everyone has an annual CGT allowance, which is 10,100 this year. Gains up to this amount can be cashed in tax-free, giving a married couple scope to realise profits of up to more than 20,000 annually.

Another advantage of Isas is that they do not need to be recorded on tax forms, making filing returns that much simpler.

Moreover, Isas have proved a powerful force in helping to encourage saving, with cash Isas attracting 200 billion and saving consumers 680 million in tax a year.

According to the Nationwide, customers who have fully maximised their cash Isa allowance over the last four years and are planning to top up this year will have built up a nest egg of 18,300. If they had stocked up on equity Isas they would now be sitting on 38,600.

The cash Isa could then give them an income of 457.50 tax-free a year, assuming an interest rate of 2.5 per cent.

The returns from cash Isas have not been very exciting, albeit they are at last rising. The average Isa variable cash rate is 2.27 per cent, compared with 2.05 per cent typically paid a year ago.

However, there are better deals if you search for them. Northern Rock has a five-year Isa which will fix your rate at 4.3 per cent if you can tie the money up. Similarly, the Halifax will pay you 4.25 per cent in a fixed Isa for four years.

These higher rates reflect the expectation that returns will climb over the coming years, which you should bear in mind before locking your cash away.

Otherwise, fixed rates of around 3 per cent are available for shorter periods of at least a year. Variable returns start below 3 per cent.

Rachel Thrussell, head of savings at Moneyfacts, said: "If you are a taxpayer it will be worth your while holding your savings in an Isa. Sometimes the tax saving is not huge, but you won't do better outside an Isa once the tax is taken into consideration."

Another area to watch is transfers. Once the Isa season gets under way, banks usually vie with each other to attract not only this year's Isa allowance but any money you have on deposit in an Isa account elsewhere.

However, following complaints about transfer delays, banks and building societies have agreed to guarantee Isa accounts must be transferred within 15 days.

As this is the first Isa season with such a promise in place, banks may want to avoid attracting too much money in case it overwhelms their administration capability.

They may, therefore, hold back from offering rates on transfers that are too attractive.

'Good returns and flexibility are vital for me'

HELPING her children with the cost of studying meant savings were always scarce for Geraldine Little, from Houston, Renfrewshire. "I paid for my daughter to go through medical college and my son through university, so there was never much if anything left over to save," she says.

But having retired early on health grounds, Geraldine found she had built up a nest egg. Getting the best return became crucial. She says: "I know the interest paid on savings at the moment is not what we would like, so I felt it was important to shop around. I examined most of the accounts on the market and opted for an Isa from Bank of Scotland, paying 2.8 per cent.

"It gave me a good return but also the flexibility to make withdrawals when I need to, which is very important for me."