Low cash ISA rates mean losing money - can you beat the system?

It's that time of year when you need to start thinking of how to use your annual ISA (Individual Savings Account) allowance. Failing to do this will mean missing out on the valuable tax avoidance benefits of these accounts.

However, even with tax-free interest, it's hard to keep pace with inflation, as the best cash ISAs on the market offer around 3%, while prices are rising 4% a year according to the government consumer price index, or 5.1% on the retail price index. So what can you do?

The ISA rules
Until April 6 every year, individuals can shelter up to £10,200 from tax in shares or investment funds within an ISA wrapper. You don't have to invest the full £10,200. Any amount will do, although you cannot claw back the tax advantages for this financial year by investing after the April 6 deadline.

For the majority of savers, 46% according to figures from fund manager Fidelity, concern about the risks involved in investing in stock and shares pushes them towards the no-risk option of cash ISAs, into which they can invest up to £5,100 each tax year, tax free.

In fact, the Fidelity research indicates that just 3% of the adult population chooses to invest in an equity ISA each year.

However, the current low interest-rate environment could make this a far more interesting option - and the only way to beat inflation and avoid losing money over the longer term.
If the idea of investing in stocks and shares - the value of which can go up as well as down - scares you, then a cash ISA remains the best choice, despite the interest rates being offered at the moment.

It is vital to shop around for the best deals, though, as some accounts are offering as little as 0.1%.

Recent research from data provider Defaqto revealed that Halifax, Santander, Virgin and West Bromwich Building Society are all paying some ISA savers 0.1%, even though they are busily marketing accounts with much better headline rates.

On this year's £5,100 cash ISA allowance, that means these people would receive a miserable £5.10 over the next twelve months.

And they are not the only ones offering uncompetitive rates. Almost one in 10 ISAs pays less than 1% a year, with some 28 out of a 334 total paying less than 0.5%, according to the Defaqto research.

However, you can earn 3% a year with Halifax's Cash ISA Direct Reward account, which is open to all savers and can be opened with a £1 deposit.

The account includes a bonus of 2.5 percentage points for the first 12 months, and pays an additional bonus of 0.2 points to existing current account or mortgage customers, bringing their rate to 3.2%.

Michelle Slade at independent analyst Moneyfacts said: "A large part of the rate is made up of the bonus, but the new rules mean ISA providers have to write to customers to advise them when a bonus is coming to an end. As long as customers remember to switch next year they can take advantage of a market-leading rate."

Meanwhile, Principality Building Society has launched a four-year fixed rate ISA paying 4.3%. It's the highest paying Isa for that period of time, although it is worth pointing out that the account does not allow any withdrawals before maturity.

With interest rates tipped to start rising over the next few months, you may also find yourself missing out on better deals before the term comes to an end.

Slade said: "While I would give this a thumbs up in the current market, I would say that if rates rise significantly in the four-year period, savers could find themselves locked into a deal that is uncompetitive in the later years."

Equity ISAs
If you have some appetite for risk, and are happy to invest your cash for a minimum of five years to get the best return, then most advisers recommend a stocks and shares ISA in the current climate.

Longer term, stocks and shares ISAs generally outperform cash savings accounts. But you need to understand that the value of your investment can fall as well as rise.

Danny Cox from financial adviser Hargreaves Lansdown said: "People who can't accept these risks ought to stick to cash ISAs."

If this sounds interesting given the low rates on offer through cash accounts, funds recommended by Darius McDermott, managing director of Chelsea Financial Services include Artemis Strategic Assets, which invests in UK and overseas equities, fixed interest, currencies, commodities and cash.

If you would like to be more adventurous, his favourites for investors with a higher risk profile are the Schroder US Mid Cap and Neptune European Opportunities funds.
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