ISA vs savings account: where should your money go?

If you’ve got money set aside and you’re staring at two options — a cash ISA or an ordinary savings account — the right choice usually comes down to one question: will you pay tax on the interest? Both are safe places to keep cash and both pay interest, but they’re treated very differently by the taxman. Here’s how to decide.

How a regular savings account is taxed

Interest from a standard savings account counts as taxable income. The reason most people never notice is the Personal Savings Allowance (PSA), which lets you earn a chunk of interest tax-free each year:

• Basic-rate taxpayers can earn up to £1,000 of interest tax-free.
• Higher-rate taxpayers can earn up to £500.
• Additional-rate taxpayers get no PSA at all.

Earn interest above your allowance and the excess is taxed at your normal Income Tax rate. So for a basic-rate saver with modest balances, a regular account can be effectively tax-free — and these accounts often advertise slightly higher headline rates than equivalent ISAs.

How a cash ISA is taxed

A cash ISA works the same way day to day — you deposit money, it earns interest — with one big difference: all the interest is tax-free, forever, regardless of how much you earn. It sits outside the PSA entirely.

The trade-off is the annual ISA allowance, a cap on how much you can pay in each tax year. Once money is inside the ISA wrapper, it stays tax-free year after year, even as the balance grows.

When the ISA wins

The ISA’s advantage grows precisely when the PSA stops protecting you:

• You’re a higher or additional-rate taxpayer. Your PSA is smaller or zero, so taxable interest bites sooner.
• You have a large balance. At higher interest rates, even a basic-rate saver can blow through £1,000 of interest with a five-figure pot — and the excess is taxed.
• You’re building savings over many years. Each year you can shelter more, and the protected total compounds.
• Interest rates are high. The same balance generates more interest, making the tax-free wrapper more valuable.

The regular account often wins when you’re a basic-rate taxpayer with a smaller balance, comfortably inside your PSA, and you’ve found a noticeably better headline rate.

The quiet power of compound interest

Whichever account you choose, compound interest is what does the heavy lifting over time. Compounding means you earn interest not just on your original deposit but on the interest already added — so your balance grows faster the longer you leave it.

This is exactly why tax treatment matters more than it first appears. In a regular account, tax skimmed off your interest each year is money that never gets the chance to compound. In an ISA, every pound of interest stays invested and keeps earning. Over a year or two the difference is small; over a decade, sheltering interest from tax and letting it compound can add up meaningfully.

A few practical pointers:

• Compare the after-tax return, not just the headline rate. A 4.5% taxable rate can be worse than a 4.2% tax-free one once tax is applied.
• Look at easy-access vs fixed-rate. Fixed-rate accounts and ISAs usually pay more but lock your money away.
• Check how often interest is paid and compounded — monthly compounding edges ahead of annual.

A simple way to decide

Run a quick mental test. Estimate the interest your savings will earn in a year. If that figure sits comfortably below your Personal Savings Allowance, a regular account chasing the best rate is fine. If your interest is likely to exceed your allowance — because you earn more, save more, or rates are high — the ISA’s permanent tax shelter is usually the smarter home. Many people end up using both: an ISA for long-term, tax-protected savings and a regular account for the everyday rate-chasing on the rest.

Estimates and general information only — not financial or tax advice. Verify figures with an official source before acting on them.