Why a tax on ISA cash interest would cost most savers less than £20

Savers could face a 22 per cent tax on any interest earned on cash in a stocks and shares ISA from April 2027 under government plans – but the amount most savers would actually pay is very small.

From next April, the government is cutting the annual cash ISA allowance to £12,000 for under-65s, down from £20,000 currently.

The aim is to get more people putting their money into stocks and shares ISAs – where you can invest your money and the returns are tax-free – with the goal of boosting the sluggish UK stock market and seeing people get better returns on their money.

As part of this, the government is working on so-called ‘anti-circumvention rules‘, which stop people finding workarounds to the policy, including banning transfers from stocks and shares ISAs to cash ISAs.

But another proposal on the cards is implementing a 22 per cent charge on any interest earned on cash sat in a stocks and shares ISA, to prevent people effectively dodging the cash ISA cut.

While the policy is very unpopular with industry experts and consumers alike, for most people, the charge wouldn’t actually deter them from holding cash in their ISA, because they would not receive a separate bill or see any money taken from their ISA balance.

Instead, their ISA provider would just hold back some of the interest, meaning they would simply be paid a bit less than expected. For many savers, the amount they would be charged would also be small.

Stocks and shares ISAs tend to pay a much lower interest rate on uninvested cash than other cash savings accounts, with many rates typically between 1 and 2 per cent. Most people hold cash while they are moving funds between different investments, or waiting to withdraw their money.

AJ Bell offers a flat rate of 1.75 per cent, while Interactive Investor pays 1.11 per cent on the first £20,000, then 1.26 per cent on up to £50,000. Hargreaves Lansdown pays 1.51 per cent on balances up to £20,000 and 1.18 per cent on balances between £20,000 and £99,999

According to AJ Bell, over half of all ISA savers typically put less than £5,000 into an ISA in 2022/23.

If those people chose to put that money into a stocks and shares ISA paying 1 per cent instead of a cash ISA next year, they would lose just £11 in interest, earning £39.

If a saver maxed out the £12,000 cash ISA allowance next year and then put the remaining £8,000 into a stocks and shares ISA and held it in cash, they would lose £17.60 in interest while still earning £62.40, assuming 1 per cent interest.

Even if a saver invested their full £20,000 allowance into a stocks and shares ISA and held it all in cash paying 1 per cent interest, they would lose £44 in interest, while still pocketing £156.

If you doubled the interest rate to 2 per cent on £5,000, a saver would lose £22 in interest while keeping £78.

For an £8,000 balance, they would pay £35.20, retaining £124.80. Those opting to put the full £20,000 in a stocks and shares ISA as cash would lose £88, keeping £312.

Tax risks disincentivising investing rather than cash ISA circumvention

Experts say the optics of the policy and how it sounds to customers is more of a deterrent than the policy itself. More likely, they say, is that it will simply disincentivise people from investing – which completely contradicts the government’s policy objective.

Brian Byrnes, head of personal finance at Moneybox, said: “For those holding small amounts of cash in their stocks and shares ISA, a 22 per cent charge on the interest they earn will probably have a negligible impact on savers’ behaviour and thankfully their ability to hit their financial goals.

“However, adding restrictions and charges to the one account designed to incentivise investing risks making it seem more complicated than it needs to be, and less appealing than it is.

“A 22 per cent charge on cash interest in isolation may not severely affect outcomes, but the long-term impact on people’s finances could be more severe if the overall package discourages them from investing.”

Tom Selby, director of public policy at AJ Bell, added that the policy is “effectively punishing people for doing the right thing” but agreed it is unlikely to have much material impact on anyone’s behaviour.

“This is definitely not a useful deterrent. Over the long term, interest rates should sit at around 2/2.5 per cent to match inflation, and stocks and shares ISAs might pay 1 per cent [interest on cash]. Will people really view this as a massive loophole in order to make a real-terms loss on their cash? I doubt it,” he said.

“In reality, savvy savers with larger savings will look elsewhere to find better rates and people holding very small amounts in those accounts won’t really notice.

“I think a much better deterrent would be simply banning firms from marketing stocks and shares ISAs as cash products. It feels like the Treasury in knots of complexity over an issue that is just pretty immaterial.”

The government is still working on finalising its ISA reforms. It was previously expected to publish the draft reforms this month, but has delayed it while it continues engaging with the industry over the technical details.

A spokesperson for HM Treasury said: “We are reforming the cash ISA to encourage more people to invest in stocks and shares – which have historically performed better than cash savings – and we have retained the generous £20,000 tax free limit.

“These changes will make people better off and will not require anyone to move existing savings from their cash ISA. The vast majority of savers will continue to pay no tax on their savings and HMT and HMRC are working at pace with industry on the detailed rules and will update on next steps in due course.”