In recent years, cash ISAs have been seen as a sound means of generating tax-efficient returns. Unlike a savings account, they have not been subject to tax on interest received. This has significantly increased their returns on a relative basis and is a reason why they became relatively popular.
However, two factors have reduced the appeal of cash ISAs. The first is tax changes on interest income received, while the second is inflation. Due to the latter in particular, it may now be time to dump your cash ISA and invest in shares instead.
Tax changes
In previous years, interest income from cash balances was taxed at the same rate as an individual’s main income. This meant that taxpayers would pay at least 20% of all interest received as tax, with as much as 40% being paid among higher rate taxpayers. Now though, basic rate taxpayers do not pay any tax on the first £1,000 they receive in interest per year, while for higher rate taxpayers the allowance is £500.
This has significantly reduced the appeal of cash ISAs. For many people, a £1,000 allowance is sufficient to cover most (if not all) of the interest they receive per year. That’s especially the case since interest rates remain exceptionally low, so even relatively large cash balances are currently generating disappointing levels of overall return. As such, having a savings account rather than a cash ISA could be a worthwhile move.
Inflation
However, the main reason why cash ISAs are declining in popularity is the rise of inflation. While inflation has been relatively low in the last decade because of a global deflationary period, it has now spiked to around 3% following the EU referendum. This has caused the interest on cash ISAs to become negative in real terms, which means that holders are seeing the value of their investments decline year-on-year.
In the long run, this could severely erode their purchasing power. And with the prospects for inflation being relatively high, it could rise yet further and lead to even greater loss of value in real terms for holders of cash ISAs.
Shares
One solution is to simply reinvest the bulk of the holder’s capital in shares. The FTSE 100 currently offers a dividend yield that is close to 4%, which means that it’s possible to obtain an inflation-beating income return while also having exposure to a wider range of companies. Certainly, there is scope for capital losses, but in the long run the index has always recovered from even its worst declines.
And for individuals seeking a higher income return, it’s possible to generate a 5%+ dividend yield in a range of large-cap stocks at the present time. Therefore, while cash ISAs had appeal in the past, changing circumstances mean that they may already have limited use in the real world.