The trouble with Cash ISAs

CashWith the tax year having just ticked over, I figured that now was a good time to say something about Individual Savings Accounts (ISAs), and in particular what I perceive to be the trouble with cash ISAs.

I used to be a big fan of cash ISAs, having opened my first one over a decade ago when Smile bank was offering a mouth-watering 7.25% (if memory serves me correctly). It served me well for a while, until I discovered...
The trouble with cash ISAs
The initial "teaser" rate on that cash ISA was not maintained, and it fell in subsequent years irrespective of the direction of the bank base rate, although I acknowledge that Smile was not one of the worst offenders in this respect.

A couple of years later, I used a new ISA allowance to invest in an alternative market-leading (at the time) National Savings cash ISA. I seem to remember that this new account would take my new tax year deposit, but would not transfer in my accumulated Smile ISA balance at the new attractive interest rate.

This illustrates the problem with cash ISAs: that it is all too easy to deposit this year's allowance into an account that offers a headline-grabbing interest rate, which then falls in subsequent years. This can leave you with a zombie account that cannot easily be transferred to a better interest rate elsewhere, and from which you daren't withdraw funds for fear of losing the "tax-free" status.

Despite a recent article in the Money section of The Sunday Times on 8 April declaring "Rate boost for cash ISA savers", the fact remains that many of the headline accounts are boosted by a one year only bonus and are restricted when it comes to transfers in.

One possible way to mitigate the problem might be to deploy each year's allowance into whichever new-issue ISA offers the highest interest rate at the time, rather than topping up an existing ISA, and then withdraw funds -- if ever you need to -- from the poorest paying (most likely the oldest) account on a kind-of first in / first out basis. Then all the time keep looking for opportunities to transfer your accumulated zombie funds held with different providers into better-paying ISA accounts that will accept those transfers. But this could require a lot of time, effort and research.

Let me offer an alternative by suggesting that...

A stocks & shares ISA might be better
One advantage of investing in a stock & shares ISA is that you can invest more money: £11,280 in the 2012-2013 tax year compared with half that amount, i.e. £5,640, in a cash ISA.

Alternatively, you can split your total allowance by depositing £5,640 in a cash ISA and depositing the balance of £5,640 in a stocks & shares ISA, but to me this is akin to investing in one of those halfway-house "have your cake and eat it" structured products that promise some safety combined with some market return. Personally, I would prefer all of the money to be at the mercy of the market, because then I'm in control.

I'm not in complete control, of course, because Mr. Market has a say in what happens to my share investments, but ultimately the return I get is a function of my own investing ingenuity. My return is not limited to the single-digit interest percentage set by the cash ISA provider initially. And it won't be cut on a whim in the second and subsequent years, thereby compelling me to open yet another ISA account.

From cash to stocks & shares
I'm not saying that cash ISAs are all bad, or always bad. They serve an important purpose for those of us who want to save tax-free with no downside risk and no obligation to fill out the details on a Self Assessment tax return. And that initial teaser interest rate can be very attractive.

Since the HMRC allows you to transfer a cash ISA into a stock & shares ISA (but not vice-versa), why not take the attractive cash ISA for the first year bonus and then -- in the second year, as soon as interest rate becomes less attractive -- transfer the accumulated cash into your stocks and shares ISA?

Foolish bottom line
Tax-free saving via an ISA is good, but it can get less good over time as the account provider ratchets down the interest rate. The return you get from a stocks & shares ISA is entirely down to you (and Mr. Market), and is not subject to the whims of the cash ISA providers that rely on your investing inertia.

Personally, I want control over my investment returns, and I'm willing to live or die by my own investment sword, so for me the stocks & shares ISA is the better option. But it's risky (in the true financial sense) and it might not be the better option for everyone.

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