Cash ISAs: the saver’s dilemma

In this special collaboration with Moneyfarm, seasoned financial journalist and commentator David Stevenson dives into one of the UK’s most misunderstood savings tools: the Cash ISA. Even for personal finance experts, the world of ISAs can be surprisingly complex. With his clear and thoughtful approach, David explores the origins, benefits and limitations of the Cash ISA — helping savers understand where it fits in a broader financial strategy, and when it might make sense to look beyond cash.

Let’s be honest – even for personal finance experts, the ISA, or Individual Savings Account regime is confusing. 

ISAs are tax-efficient ways to save or invest in the UK, shielding your interest, investment income or capital gains from tax. There’s a bewildering array of ISA types – Cash ISAs, Stocks and Shares ISAs, Junior ISAs, – but the main focus of this article is the Cash ISA: its origins, advantages, and pitfalls. 

Perhaps the most crucial point to remember from the outset is that a Cash ISA is a savings vehicle, not an investment vehicle. A Cash ISA typically offers capital protection, making it nearly – but not entirely, as we’ll discover – risk-free. That sounds like a big positive: the government allows you to save tax-free over many years. What’s not to like? However, it’s important to understand the distinction: while Cash ISAs prioritise capital preservation, investment-based ISAs, such as Stocks and Shares ISAs, carry varying degrees of investment risk, including the potential loss of capital. Recognising these differences is key when deciding how to allocate your ISA allowance.

But saving has its downsides, not least that over time, the value of cash begins to diminish. As we’ll discuss, it certainly makes sense to save and accumulate some money for various practical reasons. 

Depending on individual circumstances and risk appetite, some savers may wish to consider investment options to potentially achieve higher long-term returns, recognising that these come with increased risk to capital. This is where another ISA variation, Stocks and Shares ISAs, becomes relevant. 

Current UK ISA types and limits (2024-2025)

The context 

But first, let’s outline the historical context of the ISA, if only because it has been a long journey over time – and through acronyms – to reach our current position. Before the introduction of the ISA, the tax-efficient savings environment in the UK was primarily founded on two distinct products: the Tax-Exempt Special Savings Account (TESSA) and the Personal Equity Plan (PEP). Understanding these precursors is vital to appreciating the revolutionary simplification that the ISA was intended to bring.

The TESSA was the direct precursor to the Cash ISA. It was a deposit-based account offered by banks and building societies where individuals could save a limited amount over a five-year term, with the interest earned being completely tax-free. Upon maturity, the original capital invested (up to a maximum of £9,000) could be reinvested to maintain its tax-advantaged status. 

The PEP, by contrast, was the precursor to the Stocks and Shares ISA. It allowed individuals to invest in equities, bonds, and investment funds, with all capital gains and reinvested dividends exempt from tax. When the ISA was introduced, existing PEPs were automatically converted into Stocks and Shares ISAs. 

The introduction of the ISA represented a deliberate policy move to create a single, unified, and more accessible brand for tax-efficient saving and investing, thereby deepening the UK’s savings and investment culture. 

A pivotal moment for the Cash ISA occurred in July 2014 with the launch of the new-look ISA, accompanied by a substantial increase in the annual allowance to £15,000, which has since been raised to £20,000.

Cash ISA positives

The appeal of a Cash ISA is easy to grasp: any interest earned on the funds held within it is entirely exempt from UK income tax, which provides a significant edge over standard savings accounts, where interest income is taxable. That last point is vital – many savers erroneously believe that savings interest is tax-free. It isn’t.

Income from interest is classified as taxable income, although most UK taxpayers take advantage of a Personal Savings Allowance (PSA), which allows them to earn a certain amount of interest tax-free each year; however, this allowance is limited. 

For basic-rate (20%) taxpayers, the PSA is £1,000; for higher-rate (40%) taxpayers, it is £500; and for additional-rate (45%) taxpayers, the PSA is zero.  

With interest rates so much higher than in the 2010s, when rates were close to zero, these allowances can be quickly exceeded, making the unlimited tax-free interest of a Cash ISA particularly valuable. There’s one other advantage worth bearing in mind: unlike taxable interest, any income or gains earned within an ISA do not need to be declared on an individual’s annual Self-Assessment tax return.

These tax advantages cost the government real, hard money: the most recent estimate I’ve seen is that the Cash ISA directly involves approximately £3.8 billion in foregone revenue to the Exchequer. 

However, that estimate was for the 2020-2021 tax year, with current losses to the Exchequer likely to be substantially higher.  

For the year 2023/24, the total revenue lost from all ISAs was estimated to be £6.7 billion, with Cash ISAs likely to be the major, if not the majority, of that lost amount.

Saving versus Investing

So, let’s establish a few basic principles. The first is that Cash ISAs are a great tax-efficient vehicle and could save you hundreds of pounds a year in taxes. The next principle is that you can mix and match cash savings with riskier investments in an ISA. Arguably, though, the most essential principle is that holding too much cash, inside or outside an ISA, carries a significant, quantifiable risk.

To understand that last point, we need to consider inflation. Inflation is all around us, and for as long as I can remember, core UK inflation rates have hovered around the 2.5% to 4% range (depending on your measure of inflation). The impact of inflation should be clear – it erodes long-term asset values and purchasing power, unless those assets (cash or stocks) appreciate in value by more than the inflation rate each year. The significant cash drain arises from something called the negative real rate on savings. 

For argument’s sake, let’s assume that inflation is consistently running at 4% per annum over many years, while the long-term return on cash savings – inside or outside a Cash ISA – is 2.5%. That implies a negative real return or rate of -1.5% (2.5% minus 4%). In other words, your savings decline by 1.5% in real value terms every year. 

How might this impact someone who has, for instance, accumulated 5 years of Cash ISAs to the tune of £100,000? After five years, that cash ISA will have lost 7% of its purchasing power, but over 15 years, that loss adds up to nearly 20%. 

Holding cash in low-interest-rate environments during periods of higher inflation may reduce the purchasing power of your savings over time. This is known as inflation risk, and it is important to consider this when determining your long-term financial strategy. The cumulative effect becomes devastating. A saver who waits 10 or 15 years to address the situation has already allowed an irreversible decay in their wealth to set in.

And just in case you thought I was scaremongering about inflation being 4% for extended periods of time, or savings rates being consistently negative, consider these historical precedents. In the high inflation era from 1975 to 1979, the average bank savings rate rate was running hot at 10.8%  over this period, but the average CPI rate was running even hotter at 15.6%.

Or what about the era from 2010 to 2015, after the GFC, the ‘Global Financial Crisis’, when the average bank savings rate collapsed to an average of 0.5% but inflation was still running at over 2%. In both these periods, savers suffered net losses in their purchasing power by holding cash. 

More recently, in the last few years, there has been a shift back into positive real rates (inflation is around 3.5%, but the average high-interest cash ISA probably pays around 4%), mainly because inflation has fallen faster than the Bank of England base rate has been cut. However, the long-term historical record suggests that the last few years of real positive savings interest rates is possibly the exception rather than the rule. 

Some simple rules

Assuming you have a Cash ISA, what should savers look out for – what are the practical guidelines? The first thing to mention is that everyone’s financial situation is unique, so it depends on your circumstances and goals. The next point to note is that there are very few hard and fast rules regarding both cash savings and cash ISAs. However, I would suggest the following as a sensible minimum.

1. Always try to have at least six months’ worth of spending in cash to cover emergencies. Whether you choose to hold that cash in a Cash ISA or in a current account depends on your preferences and financial situation.
2. Don’t just keep building up incremental cash ISAs every year, year on year unless you are happy to see the real value of that wealth slowly dissipate because of inflation and its impact on purchasing power. Regularly reviewing your Cash ISA holdings can help ensure your savings remain aligned with your financial goals. Over time, inflation can reduce the purchasing power of cash savings, so it may be worth considering other ISA options if appropriate for your risk profile.
3. You absolutely can mix and match Cash ISAs with other ISAs notably Stocks and Shares ISAs. One strategy might be to accumulate enough cash in ISAs to feel comfortable to take investment risk and then subsequently switch into riskier investments in Stocks and Shares ISAs.
4. If you do have a cash ISA, make sure the rate is competitive. Until recently, many high-street banks in the UK had a poor reputation for offering market-leading rates on Cash ISAs, and their current record remains fairly poor, with some notable exceptions. Rival online platforms have been steadily gaining traction with more competitive rates that are usually only marginally below the current Bank of England base rate.
5. Cash within an ISA can be held in bank deposits, as well as in money market funds, also known as QMMFs (Qualifying Money Market Funds). These funds invest in all sorts of financial instruments within a strict set of rules that guarantee liquidity and low risk. QMMF Cash ISAs allow cash-like flexibility (you can fairly easily access the cash in the funds) with market-beating rates (when compared to many traditional deposit-based institutions like banks).
6. If the very best Cash ISA rates on offer start to trend below the current core inflation rate, then you could give serious consideration to some riskier investments that pay an income, such as fixed income securities or bonds. These are not risk-free savings, but they can be lower-risk investments – government securities or gilts are a popular choice in that regard. If Cash ISA interest rates fall below inflation, the real value of savings may decline over time. In such cases, investors may wish to explore income-generating alternatives, provided these align with their financial goals and risk tolerance.
7. Always ensure your Cash ISA provider is authorised by the Financial Conduct Authority (FCA) and that your savings are protected under the Financial Services Compensation Scheme (FSCS), which currently covers eligible deposits up to £85,000 per person, per institution. Amounts above this limit are not protected, so if the institution were to fail, any excess funds could be at risk.

I’ll conclude with one final thought. In my opinion, ISAs represent a very generous tax allowance that may not remain in their current form for much longer. 

There has been considerable discussion about altering ISAs and potentially even eliminating Cash ISAs – or, at the very least, reducing the annual limit to around £ 4,000.  While there is ongoing debate around the structure and allowances of ISAs, no formal changes have been announced. I don’t believe the Cash ISA is doomed, but I would estimate the likelihood of a significant change to its tax status to be above 25%. It’s possible, but not necessarily probable, that there will be drastic changes. 

Given the potential threat to Cash ISAs and their generosity (and cost to the Exchequer), it seems sensible for everyone to consider establishing an ISA if they can afford to, preferably with funds in both a Cash ISA and a Stocks and Shares ISA if that makes sense from a risk perspective. 

And while we are on the concluding theme of having your cake and eating it, as long as you can afford it, you should always contemplate investing in a pension alongside an ISA. Many people assume it’s either pensions or ISAs; the best solution is both, if you can manage it. It’s never ISA vs Pension. It’s ideally both!

Explore our ISA solutions

We offer a range of ISA products designed to suit different saving and investment needs. Our Cash ISA provides tax-free interest on your savings, while our Stocks and Shares ISA offers access to a range of investments, which may provide higher returns but also involve risk to capital. Junior ISAs are available for saving on behalf of children. As with all financial products, it’s important to consider whether an ISA is appropriate for your circumstances. Capital at risk in investment ISAs. Tax treatment depends on individual circumstances and may be subject to change.