For the first time in a loooonng time, the interest you get on a savings account looks like a pretty good deal. We’ve all become so used to rates below 1% that the fact you can now get rates closer to 5% seems like a massive win.
Sorry to burst your bubble, but it’s not.
In reality, 5% now is actually a worse deal than the 1% you were getting two years ago. And don’t get us started on Cash ISAs. Well, do, because we’re going to explain why putting that spare cash into a Cash ISA is a complete waste of time for more reasons than one.
And it’s important, because we’re smack bang in the middle of ISA season. With just a few days left until the tick over into the new tax year, you need to know how best to use one of the biggest no-brainers in financial planning, the annual £20,000 ISA allowance.
If you don’t have time to waste and you just want to get your cash into an investment ISA ASAP, get in touch with us today.
It’s a famous investment saying, and it's famous because it’s completely true. No one has ever saved their way to major wealth. Cash has a number of useful purposes (which we’ll get to in a bit), but it’s a terrible vehicle for wealth creation.
The reason for that is because it’s intrinsically tied to central bank interest rates, which are intrinsically tied to inflation. When inflation goes up, so do rates. When inflation goes down, so do rates.
That means that the only time you get high levels of interest on your cash is when the cost of the goods and services that you can buy with it are going up by even more.
So if you have a bank account offering you 6% interest, but inflation is going up by 8%, you’re still guaranteed to lose money in real terms. Every. Single. Year.
Here’s a quick illustration.
Say you have £100 and you want to spend it on cans of Coke, which cost £1 each. You can buy 100 cans.
But now imagine that you see an ad online for a bank account which is offering you 6% interest on your money.
“Hmmm”, you think.
“If I just wait a year, I could buy 106 cans of Coke without having to lift a finger. It’s free money. It’s free Coke!”
So you put the money in the bank account and watch the interest trickle in. In a year's time, you’ve got £106 and you’re ready to load up on sugar. But there’s a problem. Inflation has been running at 10% over the last 12 months, which means a can of Coke now costs £1.10.
When you go to tally up your purchase, your £106 only buys you 96 cans of Coke.
Your balance has gone up, but you’ve gotten poorer.
This might seem like a silly example, but it is exactly how inflation destroys your wealth over time if you’re not generating returns over and above it. Consider a larger, more realistic number. Instead of £100, say we’re talking about £500,000 that you have sitting in cash.
If the differential between inflation and your cash interest rate is 2%, that means the real value (or purchasing power) of your money will go down by £10,000 by the end of the year. Compound that for 10 years and your £500,000 will be worth £409,000 in real terms.
It’s active wealth destruction, and it’s guaranteed every year for every pound you invest in cash.
Does that sound ‘safe’ to you?
So cash is a poor place to keep your money. But keeping it in a Cash ISA is even worse. The benefit of using an ISA wrapper is that everything you put in goes in tax free, grows tax free and can be withdrawn whenever you want, tax free.
That makes your £20,000 annual ISA allowance super valuable, and using it to put money in a cash account is a complete waste.
Let’s take a look at how much tax you’d save if you used a Cash ISA for 10 years, as opposed to an Investment ISA over the same period.
We’ve kept this simple, so it assumes tax free allowances have already been used.
If you’re going to have some cash and you’re going to have some investments (which you should, more on that below), it makes no sense to have the low interest, nil capital growth assets in the tax free account.
The longer these funds stay in the account, the bigger the tax benefits you receive. You could hold funds in an ISA for 100 years, generate millions of pounds in capital gains and never have to pay a penny of capital gains tax.
Much better than saving a little tax on bank interest each year.
Ok, keeping some cash makes sense. We usually recommend maintaining a cash emergency fund of around 3-6 months living costs. This means you can get quick access to funds if you have any short term cash flow issues (hello Silicon Valley Bank) or unexpected expenses.
That figure will still be eroded by inflation, but it will be highly liquid. You can get access to it immediately. That’s what cash is good for.
Other than that, there are many different places to put the rest of your investments and savings that are aimed for the long term. An Investment ISA is something everyone should consider, but most of our clients have significantly more than £20,000 a year to invest, so it’s not going to be the only type of account they hold.
Remember that ISA’s are individual accounts, so if you have a partner then they can fund an ISA themselves each year as well.
Depending on your circumstances, SIPP (Self Invested Personal Pension) can make a lot of sense as well. You’re locking the money away until you reach age 55, but it comes with attractive tax advantages that are similar in many ways to an ISA (not as good though).
Beyond that, you’re looking at taxable investment accounts. But just because they attract tax doesn’t mean there aren’t strategies that can be used to minimise it. The benefit of a diversified investment portfolio of stocks and ETFs over other assets like real estate or private equity, is that future capital gains can be managed very well.
So, to summarise, this is the hierarchy that many investors should consider when working out where to put their funds.
Cash emergency fund of 3-6 months living expenses
£20,000 into an Investment ISA (not a Cash ISA) - each for members of a couple
Up to £60,000 into a SIPP - depending on income and personal circumstances
Further funds into a General Investment Account
This isn’t going to be right for everyone. Depending on your own circumstances, for example, you might want to skip using a SIPP altogether.
The key takeaway is that if you’re looking to get funds into an ISA before the end of the current tax year, and you’re considering just using a Cash ISA, don’t. You’ll be making a mistake that could add up to tens or even hundreds of thousands of pounds of missed tax savings in the future.
Want to talk through how this impacts you personally, and how to best structure your own finances? Get in touch with Rosecut today.