When it comes to saving money, choosing the right account can make a significant difference in how much interest is earned and how much tax must be paid.

In the UK, two common options for savers are Cash ISAs (Individual Savings Accounts) and regular savings accounts. While both help consumers grow their savings, they do so in different ways, as a Cash ISA offers some unique tax benefits.

One of the main reasons people opt for a Cash ISA over a regular savings account is the tax-free status of the interest earned.

With a Cash ISA, all the interest earned is completely tax-free, regardless of how much is saved.

In contrast, interest earned in a regular savings account is subject to tax if it exceeds a Personal Savings Allowance (PSA).

The Personal Savings Allowance (PSA) is the amount of interest earned from regular savings accounts each tax year before a consumer must pay tax. The PSA is defined by an individual's income tax band.

If an individual's savings interest exceeds their PSA, the excess is subject to tax at their applicable income tax rate.

Some people don’t pay any tax on savings interest, even if they use a regular savings account. This is because they earn below the Income Tax Personal Allowance, which is currently £12,570 per year.

For individuals earning less than £12,570 per year, the Starting Rate for Savings provides extra tax-free interest. The Starting Rate for savings is a tax break on interest worth up to £5,000, aimed at those on a lower income. If an individual has used up their personal allowance, then it can help reduce the tax bill on savings:

• If the total income is below £12,570, a person can earn up to £6,000 of tax-free interest (£5,000 Starting Rate + £1,000 PSA).
• If the total income is between £12,570 and £17,570, the Starting Rate for Savings gradually reduces.

If a person holds a regular savings account, their bank or building society is required to report interest payments to HMRC under the Banks and Building Societies Interest (BBSI) system. BBSI reports include details of all interest payments made to the individual during the tax year.

If an individual owes tax on their savings interest, HMRC collects it in one of three ways:

• Through the PAYE Tax Code: If someone is employed or receives a pension, HMRC may automatically adjust the tax code to collect the tax owed from their salary or pension payments, based on the information submitted by their Bank or Building Society in the BBSI report.
• Self-Assessment Tax Return: If someone earns a significant amount of interest, especially if they’re self-employed or a high earner, they may need to file a Self-Assessment tax return to declare and pay any tax owed.
• Direct Payment to HMRC: If HMRC calculates that someone owes tax on their savings and they don’t file a Self-Assessment return, they may send that person a bill asking for direct payment.

Unlike regular savings accounts, where banks report interest earned, ISA managers' report ISA contributions to HMRC. Each year, ISA managers must submit an annual ISA return to HMRC.

This report includes:

• The total amount of money contributed to an ISA within the tax year.
• Details of any transfers between ISA providers.
• Confirmation that contributions are within the annual ISA limit (£20,000 in 2023/24 tax year).

Importantly, ISA managers do not report an individual’s interest earned within a Cash ISA to HMRC, as it is tax-free.

Since an individual’s £20,000 annual ISA allowance is shared across all the ISAs that they subscribe to within a tax year, HMRC cross-checks all ISA returns from different providers to ensure individuals don’t exceed their £20,000 annual ISA allowance.

If a person over-contributes, HMRC may contact them and their ISA manager and require them to remove excess funds, and any interest earned on those excess subscriptions.

With a Cash ISA, the interest remains outside of HMRC’s tax calculations, unlike regular savings accounts where interest is monitored and taxed. This offers some advantages, including:

• Simplifies tax reporting as there’s no need to include ISA interest in a Self-Assessment return.
• Avoids unexpected tax bills as there are no adjustments required to a PAYE tax code due to savings interest.
• Protects individuals from future tax changes. Even if the Personal Savings Allowance is reduced, the ISA interest stays tax-free.

The £20,000 Cash ISA limit per tax year means individuals can gradually build up a large tax-free savings pot over time. Unlike regular savings accounts, where growing balances may push an individual’s interest over the Personal Savings Allowance, an ISA allows for tax-free growth.

With just under £300 billion estimated to sit in Cash ISAs, they’ve proven to be a very popular savings account since their inception in 1999, but as the new Government aims to boost economic growth, there are discussions underway which may impact how Cash ISAs can be used in the future.

For example, a number of investment firms are lobbying the Government to reduce or eliminate tax breaks on Cash ISAs to encourage investment in stocks and shares.

However, Cash ISAs are an important source of deposits for funding loans by banks and building societies such as mortgages and are particularly beneficial for individuals who may need quick access to their funds. As proponents highlight, they also offer a way for individuals who do not want exposure to short-term stock market fluctuations to set aside money over the medium term.

Shaun Moore of wealth management firm Quilter suggested a need to “shift the UK’s savings culture towards investment” but added: “Cash ISAs still have a crucial role and removing them entirely would hit risk-averse savers, retirees, and those building emergency funds the hardest.”

While Cash ISAs are under increasing scrutiny from the Government and investment firms, they remain an integral savings product for UK consumers with several benefits including:

• All interest is tax-free, making it ideal for higher-rate taxpayers or those with significant savings.
• No reporting to HMRC on ISA interest, removing tax complications.
• HMRC tracks contributions across ISA providers, ensuring compliance while maintaining tax benefits.
• Account holders can avoid potential future tax changes that could reduce their Personal Savings Allowance.
• Encourages disciplined saving, helping individuals build wealth over time.

Though Cash ISAs are an excellent tax-efficient savings product for retail customers, they can be a challenging product to launch and manage.

Recognising this, ClearBank launched its Cash ISA product in January 2024, to enhance our Embedded Banking proposition and offer firms the ability to launch high-quality savings products, leveraging our banking licence and infrastructure.

ClearBank can take care of the accounts, ISA tax wrapper, payment services, interest accruals and the HMRC reporting, saving our partners time and cost of becoming a bank and an ISA Manager. You can read more about the ClearBank Embedded Banking Cash ISA here.

Disclaimer: ClearBank does not offer tax advice and tax treatment is dependent on an individual’s financial circumstances.