Rates fall but cash ISAs still offer perks

The run-up to 5 April should be the busiest time of the year for savers opening a cash individual savings account. Banks and building societies normally vie for savers' attention by launching increasingly competitive interest rates and the tactic works: last year £4.32 billion was deposited in these tax-free savings accounts from the beginning of January to the end of March.

But the start of 2013 could not be more different. Never have cash ISAs looked less attractive. The average cash ISA rate this January was 1.87%, down from a peak of 5.5% in November 2007, and 0.69 percentage points less than January 2012.

Most of the interest rates on offer are no match for inflation - the Consumer Prices Index stood at 2.7% in January. At the time of writing only 10 cash ISAs beat inflation - the highest rate of 2.96% coming from First Direct, but you must have a current account with the bank and a minimum ISA balance of £40,000. 

Instead of increasing rates to attract savers' money, banks and building societies have been lowering interest rates or withdrawing accounts altogether. "No one wants to be at the top of the best buy tables," says Charlotte Nelson of the financial data provider Moneyfacts. This reluctance to take deposits has been caused unwittingly by the government. To encourage banks to be more forthcoming with mortgages and business loans, last August it provided them with a cheap source of money through the £80 billion Funding for Lending Scheme.

The money is beginning to filter through to borrowers: the cost of two-year fixed-rate mortgages for borrowers with a 25% deposit decreased from 2.66 to 2.12% between August and December last year, according to Bank of England figures.

But the scheme has had an unforeseen side-effect because it now means the banks no longer need to take in savers' deposits to be able to lend. As a result, they withdrew 351 savings accounts in 2012 alone, according to Moneyfacts, and have slashed interest rates on those that remain, making life even tougher for those who depend on savings interest to supplement their income.

Andrew Bailey, head of prudential regulation at the Financial Services Authority, has told MPs "the jury is still out" on Funding for Lending. "What we've seen since the introduction of the [scheme] is quite a marked change in rates paid on deposits."

Cash ISAs: Rules you need to know

As interest rates are so low, you are likely to want to transfer money in your cash ISA to a higher-paying account when rates rise. Make sure you know the rules before you take any action so you don't lose money:

• You can use up to £5,640 of your £11,280 total ISA allowance to deposit money in a cash ISA in the 2012/13 tax year. This rises to £5,760 in 2013/14.
• You can only have one cash ISA in a tax year, but you can open a new cash ISA with a different provider each year.
• You do not have to report interest earned by your cash ISA in your self-assessment tax return.
• Any leftover cash ISA allowance can be used for investment in a stocks and shares ISA, although the reverse is not possible.
• You can move your cash from one cash ISA to another provided the two schemes allow for transfers. ISA providers cannot stop you transferring your money, but may charge you. Many cash ISAs do not accept transferred money - only new deposits using that year's ISA allowance.
• It's important to ask the new ISA provider to arrange the transfer. If you simply cash in an existing ISA with the aim of moving the money into a different product, you will lose that portion of your tax-free allowance for the tax year in which you took out the cash ISA.
• If you want to transfer money that you have put into your cash ISA in the current tax year, you must transfer all of it.
• You can transfer money from a cash ISA to a stocks and shares ISA, but you can't transfer money from a stocks and shares ISA to a cash ISA.
• If you have transferred current-year payments into a cash ISA to a stocks and shares ISA, you can still deposit more in a cash ISA provided you have not used your full ISA allowance.
• Keep an eye on cash ISA interest rates to see if you should switch.

So is it worth opening a cash ISA this tax year? "Yes," says Nelson. "Savings rates are low across the board, but at least with a cash ISA you are earning interest tax-free."

The annual cash ISA allowance - £5,640 in the 2012/13 tax year - is also time sensitive. If you don't use it before 6 April, you will lose it for good. "Better to use that allowance now, then when rates improve in the future you won't miss out on the higher tax-free interest available," she says.

Andrew Hagger, personal finance expert with MoneyComms, agrees: "The whole savings market has gone to pot. Usually at this time of year it's a mad scramble to open an ISA, but this time it might be a damp squib. I still think it's worth people putting money into cash ISAs - you can build up your capital even if you are earning next to no interest, and it's particularly important for higher-rate taxpayers who would otherwise lose 40% of the interest to tax."

However, savers need to be careful about what type of cash ISA they select, he warns. The Funding for Lending Scheme is scheduled to last for another 12 months, and when it ends, lenders will need savers' money again and interest rates should rise as competition hots up. "I wouldn't be tempted to lock my money up in a long-term fixed-rate account at the moment. If you are worried that interest rates may fall further, and still want to opt for a fixed rate, I'd go for one that lasts just one year," Hagger says.

Given the low rates available on cash ISAs, some savers may feel tempted to use their ISA allowance to invest tax-free in stocks and shares rather than cash. Financial advisers believe such a move depends on the investor's attitude to risk and the rate of tax they pay.

Mark Dampier, investment expert at Hargreaves Lansdown, says: "Investing should improve your life, but it's not going to improve your life if you worry about it all the time. A lot of people are better off in cash, full stop."

Growth investors with small portfolios may not benefit tax-wise from using their cash ISA allowance to invest in stocks and shares, as any gains they make are likely to be within their annual tax-free capital gains tax allowance, currently £10,600.

However, Dampier urges caution here. He points out that anyone who has used their full tax-free allowance since the 1987 launch of personal equity plans - the precursor to ISAs - may now have a portfolio worth in excess of £200,000. "If you had that amount invested outside the protection of ISAs, you would only need to see growth of just over 5% for your gains to be liable to capital gains tax," he says.

Martin Bamford, managing director of chartered financial planners Informed Choice, says whether income-seeking investors benefit depends on whether they pay the basic or higher rate of tax. Because ISA managers cannot reclaim the tax credit on UK dividends, basic-rate taxpayers get no tax benefit from holding dividend-producing shares or equity-based funds within a stocks and shares ISA. Basic-rate taxpayers are taxed at 10%, which is the same as on shares held outside an ISA. However, higher-rate taxpayers do gain - they pay tax at 10% rather than the 32.5% for non-ISA investments.

Attractive alternatives to ISAs are thin on the ground. Bamford says: "We wouldn't recommend structured products for savers because they involve counter-party risk, which is difficult to quantify and usually too much for a saver to tolerate. They also mean locking your savings away for five to six years in most cases, during which time interest rates could have improved."

The National Savings & Investments range is offering very low rates of interest in line with the rest of the market, and their popular index-linked certificates are not currently on sale.

Bamford adds: "With such dire interest rates available, savers might consider premium bonds for the chance of winning a tax-free prize, instead of interest on their savings. While the interest rate used to calculate the prize fund is a paltry 1.5%, savers with premium bonds stand the chance of winning prizes ranging from £25 to £100,000, with a £1 million jackpot." But he warns that price inflation is likely to erode the value of your savings over time, "unless you get lucky and win".