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Introduction to cash

Whether you view your money as nothing more than the means to an end or the ultimate security blanket, one thing's for sure, you need to look after it. We look at how to get the most from your hard-earned cash.

The value of investments can fall as well as rise and you could get back less than you invest. If you’re not sure about investing, seek independent advice. Tax rules can change and their effects on you will depend on your individual circumstances

What you’ll learn:

  • How interest rates affect your savings.
  • How inflation eats into your savings.
  • How your returns are taxed.

The value of saving

Having savings readily available can provide us with more choices and freedom in life, whether it’s money for holidays, home improvements or school fees. But most importantly it gives us financial security. As such, it’s a good idea to conduct a personal audit and think about setting up a savings account, if you haven’t already done so. Financial advisers usually recommend having a cash buffer, which would last you at least six months, should something occur to interrupt your income stream.

Modern living can feel like a never-ending conveyor belt of expenses and while getting into the habit of regular saving might not be easy, it's well worth doing. Even putting away something small every month can make a big difference in the long run. One of the big benefits of saving regularly is the impact of compound interest. And the impact of this will help your cash to grow more rapidly because you’re not only enjoying interest on the money you’ve saved - you’re also earning interest on this interest. For example if you put a £10,000 lump sum into a savings account paying 1% per annum, by the end of year one you’d have £10,100, and so in year two you’d be earning interest on an even higher amount, and the sum will rise further as the years go by.

Remember there are a variety of savings account types to look at, which could help you get into the savings habit. Regular Savings accounts, for example, can be a good starting point, as with these accounts you need to generally pay in a set amount every month usually for a year to earn the interest on offer.

Living without interest

Unfortunately for savers, the backdrop over recent years has been anything but rewarding. Back in March 2009, in a bid to prop up the UK economy during the financial crisis, the Bank of England’s Monetary Policy Committee (MPC) cut the base rate to just 0.5%, then again to 0.25% in 2016. While this has been great news for borrowers, it’s been anything but for savers as banks and building societies have cut their deposit rates to the bare minimum. Until interest rates begin to start rising once again, achieving the best possible interest rate these days requires savers to put some legwork in to find the best deals. And the job isn’t over once you've found an account. You have to watch that the rate doesn't drop, monitor what others are offering, and be prepared to switch to ensure your savings aren't getting less of a return than they could.

Risks to your savings

Inflation has often been called the ‘silent assassin of savings’. After all, inflation marks an increase in the cost of everyday items and the higher it rises the more it devalues your cash and therefore, its spending power. If you’re shopping around for a decent savings account always try to find an account that if possible at least matches and ideally exceeds, the current rate of inflation.

Taxing returns and allowances

If the interest rate you find does exceed the rate of inflation, then all that hard work you've done finding that good rate can be undermined by income tax, which can reduce the total return savers receive. However, as a result of the Personal Savings Allowance (PSA), which came into effect on 6 April 2016, it now means:

  • Basic rate taxpayers (20%) can earn up to £1,000 in interest tax-free
  • Higher rate taxpayers (40%) can earn up to £500 in interest tax-free
  • Additional rate taxpayers are not entitled to any Personal Savings Allowance.

Find out more about the Personal Savings Allowance (PSA)

The introduction of the PSA means that for majority, their savings will be tax free, so their main challenge will be simply hunting down an account paying the highest interest rate.

Cash ISAs

Don’t forget Individual Savings Accounts (ISAs), which have a maximum contribution allowance of £20,000 in the 2017-18 tax year. The benefit of saving in an ISA is there’s no tax to pay on any interest earned for basic, higher or additional rate tax-payers.

Cash ISAs may now appear less attractive following the introduction of the PSA as the majority of people no longer have to pay tax on income derived from savings. However, if interest rates start to rise, you’ll need to save much less to reach the £1,000 or £500 thresholds, unless of course the PSA limits rise too when this happens - although there’s no guarantee that this will happen.

Remember that any interest or income you earn from either cash, investment, innovative finance, or lifetime ISAs doesn’t count towards your PSA, so ISAs are still well worth considering as part of your overall long term savings and investment strategy, especially if you’re in the additional-rate tax bracket and/or a big saver.

For example, if you’re a higher rate taxpayer and find your savings interest breaches the £500 PSA limit, it means you’ll be taxed £40 on every £100 in interest you earn above the threshold. On top of that, additional rate taxpayers don’t enjoy a PSA and for every £100 in interest earned, they’ll only get £55 after tax.

So depending on your circumstances, cash ISAs could still be advantageous, although you should always compare the rates on offer with those provided by non-ISA accounts. Notably if you’re a diligent saver and cash ISAs do suit your needs but you find that you regularly reach your annual contribution limit, you’ll need to investigate and find the best non-ISA deals available to you. You could for example look at fixed rate savings accounts, which generally have better interest rates on offer compared to basic deposit accounts. However you need to be sure you won’t need to withdraw the money in a hurry as you’ll usually have to commit to locking your cash away for a set period of time, typically anywhere between one and five years. While you can typically still access your cash if you need it an emergency, you’ll have to pay a penalty and you’re likely to lose some or all of the interest you’ve accrued.

You need to bear in mind that tax rules might change in future and that their effects on you will depend on your individual circumstances.

Protection matters

Cash deposits made with financial institutions authorised by the Prudential Regulation Authority1 (PRA) are covered by the Financial Services Compensation Scheme (FSCS) which has a maximum compensation limit of £85,000, as of January 2017.

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