What's better: a cash ISA or a regular savings account?

What do we mean by a regular savings account?

A regular savings account is designed for you to deposit any money you don't need for day-to-day spending somewhere it can be earning interest for you. There are different types of savings accounts, including:

• Instant-access savings accounts

These accounts allow you to take money out whenever you need it. This flexibility usually means you'll take a hit in terms of how much interest you can earn.

• Limited access savings accounts

These accounts are likely to limit you to a certain number of withdrawals per year before you are penalised with reduced interest rates.

• Fixed-rate savings accounts

This is where you'll find the most attractive interest rates. If you can afford to put money away without needing to access it for a set period of time – usually at least one year – you can benefit from the highest available interest rates.

With regular savings accounts, any interest you earn over a certain threshold (known as the Personal Savings Allowance – PSA) is liable for tax.

The maximum you can earn in interest is determined by your income tax rate. Current limits are (and remember, this is interest earned, not how much you have saved):

• Basic rate taxpayers: £1,000
• Higher rate taxpayers: £500
• Top rate taxpayers: £0

What is a cash ISA?

Cash ISAs belong to the Individual Savings Account (ISA) family. Any money you earn on interest in a cash ISA is exempt from tax. There are limits to how much you can save in a cash ISA, however. For the tax year 2024/25, the allowance is £20,000.

Different cash ISA providers may offer different rates of interest and some will permit you to remove money without your annual ISA allowance being affected, while others won't.

Historically, regular savings accounts have typically offered higher interest rates for savers than cash ISAs.

Even back when interest rates on regular savings accounts were at historic lows, savings accounts still offered better returns than cash ISAs. But with the arrival of some very enticing cash ISAs in recent weeks, the gap has started to close, making the decision on which vehicle to choose for your savings a bit more cloudy.

Here's what I mean:

Regular savings accounts – a selection of the top earners, May 2024

• First Direct – 7% fixed for one year, not flexible, closing the account early incurs big penalties
• Co-operative – 7% variable for one year
• Nationwide – 6.5% variable for one year
• Natwest/RBS – 6.17% variable, savings limited to £5k
• TSB – 6% fixed for one year
• Halifax – 5.5% fixed for one year, not flexible
• Lloyds – 5.25% fixed for one year
• Santander – 5% fixed for one year

Cash ISAs – a selection of the top earners, May 2024

• Trading 212 – 5.2% APY
• Plum – 5.17% AER, easy access
• Chip – 5.10% variable, flexible

Not much in it, but savings accounts still seem like they're the better option, right? Well, it's possible they could be, but there's one key difference between savings accounts and cash ISAs that means it's not quite as clear-cut as those figures suggest.

• While you will never need to pay tax on any interest earned within a cash ISA, savings accounts are not exempt from tax.

All UK savers are entitled to what's known as a ‘personal savings allowance' (PSA). That means a certain amount of interest can be earned on your saved cash, before any tax is due. However, after that point, you will need to declare your earnings and pay tax on the additional interest.

Under current rules:

• Basic 20% rate taxpayers to receive up to £1,000/year interest tax-free
• Higher rate (40%) taxpayers can receive up to £500/year interest tax-free
• Top rate (45%) taxpayers do not get a PSA

That's interest, remember; not what you hold in your savings account.

When interest rates were at their recent lowest, Basic rate taxpayers may have had £150k saved before they reached their PSA limit. However, at current rates, a Basic rate taxpayer may reach their limit with just £20,000 saved.

With a cash ISA, you will never need to pay tax on any interest you earn. Of course, there is a limit to the amount you can save this way – the maximum you can pay across all your ISA accounts during the tax year 24/25 is also £20,000.

Traditionally, the people who most obviously benefitted from the tax-free benefits of a cash ISA were those who had already maxed out the personal savings allowance on their regular savings account. When regular savings accounts had better interest rates than cash ISAs, the regular savings account was the more attractive place to put your savings as it gave you better returns. Only then, once you'd reached your PSA limit, would it be worth switching to a cash ISA as it allowed a further £20,000 to be saved tax-free, albeit at a lower rate of interest.

However, with interest rates on cash ISAs now reaching the same levels, or exceeding rates paid by normal savings accounts in some cases, the decision isn't as clear cut.

So let's do some calculations.

Let's make the assumption that you want to put £20,000 into a savings account, you're a Basic rate taxpayer, and you haven't used any of your PSA yet this year.

There are circumstances where you may be entitled to further tax-free income from interest, such as if you're earning under £17,570 per year. If you want more information on whether that applies to you, you'll find details on this UK government web page. But, I'm going to assume this additional allowance doesn't apply in this scenario.

With a cash ISA paying out at the current top rate of 5.2% APY, you could earn £1040 interest, tax-free, on your £20,000 savings this year.

With a regular savings account, paying out at the current top rate of 7%, you could earn £1400 this year. However, as you've now crossed the £1,000 PSA tax threshold, you'll need to pay tax on that extra £400. As you will be taxed at your usual rate of Income Tax (20% currently), you'll need to complete a self-assessment tax return, report the interest you've earned and most likely find yourself with a tax bill of £80 to pay.

In this scenario, that leaves you better off with a regular savings account, by £280.

However, you may decide it's simply not worth it for the hassle of completing a self-assessment tax return if you don't already have to complete one.

Let's take the same assumptions as above except this time, you're a Higher rate taxpayer, paying tax at 40%.

That also means you only have a £500 PSA. The total you're left with from that 7% fixed interest savings account, is £1040.

That means you'd earn exactly the same in interest from a regular savings account offering 7% as you'd earn in a cash ISA offering 5.2% interest.

This time, let's assume you still want to save £20,000, but you want flexibility so you can potentially take money out of those savings during the year. The First Direct account doesn't allow for that, and you don't want a variable deal. So you go for a provider offering 5.5% fixed deal with penalty-free withdrawals. And you're a Higher rate taxpayer.

How do the maths work out this time?

With a savings account paying 5.5%, you'd earn £1100 in interest. You need to pay 40% tax on anything over £500 as you're a Higher rate taxpayer. That leaves you £360. You're clearly better off with the Cash ISA in this situation.

This time, you're a Top rate taxpayer. That means you don't get a PSA, so everything you earn in interest is liable for tax.

Assuming you put £20,000 into that top-earning First Direct savings account paying 7% interest as you're happy to lock your money away for the year.

With 45% tax due on all of your £1,400 interest gains, you end up with £770. Compared to the £1,040 you can take tax-free from the 5.2%-paying cash ISA, that's peanuts.

As a Top rate taxpayer, your money is much better off in a cash ISA. However, you'll need to remember that by maxing out your cash ISA allowance, you have no allowance left for any stocks and shares ISAs you might be considering.

The next question you need to ask yourself is whether your money could be gaining better returns in an investment product. That is, of course, a decision no-one can make for you as it very much depends on your feelings towards risk. Greater potential rewards come with greater risks. If you like peace of mind, 5.2% guaranteed returns is nothing to be sniffed at.

Depending on your circumstances, it can still be better to save into a savings account, and if you have more than £20,000 in savings, a combination of the two accounts could work out your best option. However, with cash ISA rates at the levels they now are, the old assumption that you'd get better interest rates in a regular savings account, is no longer correct.

One thing to note, however, is that Cash ISA rates may drop after the first year, so it pays to keep shopping around, year on year.

If you're unsure of the right path for your circumstances, always consult a qualified financial adviser who can help understand your risk profile and which path is most likely to help you reach your financial and lifestyle goals.

The rates quoted in this article were correct at the time of publication and are monitored for accuracy.

However, as interest rates fluctuate regularly, we recommend visiting providers' own websites before making any firm decisions.