Tax on cash but money market funds spared in ISA rule change

Chancellor Rachel Reeves. Photo: Yui Mok - WPA Pool/Getty Images.

A new flat-rate charge of 22% will be applied on interest paid on cash within a stocks and shares ISA or innovative finance ISA from the start of the next tax year – 6 April 2027.

However, money market funds, which were subject to speculation they would be included in this tax charge amid concerns they would be treated as “cash-like”, will not be affected. Money market funds can be held as long as they do not comprise 100% of the value of investments in a non-cash ISA.

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The move to introduce a tax charge on cash within a stocks and shares ISA is part of the government’s efforts to create more of an investment culture in the UK and boost flows into such ISAs. 

Of approximately 15 million adult ISA accounts taken out in the 2023-24 tax year, just under 10 million subscribed to cash ISAs versus just over four million for stocks and shares ISAs.

In the Autumn Budget last November, Chancellor Rachel Reeves announced a future cut to the annual cash individual savings account (ISA) allowance to £12,000 for those under the age of 65. The cut will take effect from 6 April 2027.

The Budget document following Reeves’ speech stated that the move to reduce the cash ISA limit is “part of a wider strategy to develop a retail investment culture”.

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In addition, transfers from stocks and shares ISAs into cash ISAs will be banned from the start of the next tax year. However, transfers from a cash ISA to a stocks and shares ISA will still be permitted.

The 22% rate is in line with the incoming savings interest rate tax change, which also kicks in from 6 April 2027. 

The rule change is a retrograde move, as prior to 2014 there was 20% tax on interest paid within investment ISAs, a feature that then-Chancellor George Osborne removed as part of package of sweeping ISA reforms.

In a short announcement, which noted that further details will be announced at a later date, the government said it is “confirming the anti-circumvention rules to support reforms to ISAs announced at Budget 2025 as part of the government’s wider strategy to develop a retail investment culture. 

“To prevent circumvention of the lower cash ISA limit, the rules will introduce a 22% charge on interest paid on cash holdings held in stocks and shares and innovative finance ISAs (non-cash ISAs), prevent transfers from non-cash ISAs into cash ISAs for the under 65s, and prevent holding 100% money market funds in non-cash ISAs.”  

In an additional document called ‘ISA reform 2027: anti-circumvention rules factsheet’ it states: “Cash-like assets will be eligible for non-cash ISAs, provided that they are partial allocations and do not make up 100% of the investments in an individual’s non-cash ISA account. From April 2027, cash-like assets will be defined as money market funds only and we will require ISA managers to report their market value via the established end-of-year statistical return.”

On the one hand, taxing interest on cash in a stocks and shares ISA adds complexity to the tax-efficient wrapper. Time will ultimately tell whether this is off-putting, particularly for novice investors.

One thing for sure is that ISAs will become less straightforward from next April due to the various changes that will take effect from then.

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Moreover, the rule change also poses some questions and raises the prospect of potential complications, such as when investors sell a fund or rebalance a portfolio, as the proceeds go into cash. If an investor does not immediately decide where to reinvest that money and leaves it in cash for a short period, there’s now the prospect of a tax charge if interest is earned on cash. 

In addition, some investors like to hold some of their portfolio in cash if they are nervous about prospects for stock markets. Others, at the end of the tax year, park money in cash to make use of that year’s ISA allowance before deciding where to invest it. Again, time will tell whether the charge on cash in a stocks and shares ISA leads to a change in behaviour.

However, keeping money market funds outside this new tax will be welcomed by investors. Such funds, while low risk, are investments and therefore different from cash savings.

Money market funds own a diversified basket of safe bonds that are due to mature soon, normally within just a couple of months, meaning that investors can earn an income on their cash with minimal risk. These funds can also put money into bank deposit accounts and take advantage of other “money market” instruments offered by financial institutions.

Returns, although never guaranteed, are typically in line with the Bank of England base rate. There’s typically a little bit of a lag before the fund yield rises or falls in response to interest rate changes. Check out our recently updated article on money market fund yields.

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In a nutshell, money market funds are designed to be low-risk, straightforward products that behave in a cash-like manner. Such funds are utilised by some investors in the run-up to retirement in order to reduce risk and preserve capital.