Savings accounts have battled their way back onto Brits’ radar, offering attractive rates to beat the Bank of England’s base rate and inflation. But when it comes to getting more bang for your buck, they have some stiff competition from tax-efficient pensions, for those who already hold an emergency savings pot.
Inflation is slowing, with the latest data for January putting CPI inflation at 3%. Consequently, the Bank of England is gradually reducing the base interest rate – it is currently 3.75%, with the next BoE decision due on 19 March.
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Mike Ambery, retirement savings director at Standard Life, said: “Higher interest rates can lull people into thinking their cash is working harder than it really is.
The impact of tax on savings
Many savers make use of ISAs to keep all of the gains they make from savings interest. But those who have already used the full £20,000 annual ISA limit and are now holding cash in taxable savings accounts, may face a much larger bill than expected due to the savings tax trap.
With income tax bands frozen until 2031, more people are moving into higher and additional rate brackets each year – in what’s known as fiscal drag – making tax on interest a growing issue for households who may not realise they’re affected.
Once your savings interest exceeds tax-free allowances, it is taxed at your marginal income tax rate, so 20% for basic rate taxpayers, 40% for those in the higher band and 45% for additional rate taxpayers. From April 2027, this jumps to 22%, 42% and 47% respectively.
Higher rate taxpayers only need around £11,000 in a non-ISA cash account earning 4.5% interest before their £500 personal savings allowance (PSA) – the amount of savings interest they can earn tax-free – is used up and interest begins to be taxed. Even before inflation is considered, this reduces returns significantly.
For higher rate taxpayers with larger amounts held outside an ISA in taxable accounts, the benefits of even the best buy cash savings rates are eroded away further by tax and inflation.
For a higher rate taxpayer holding £30,000 in a taxable savings account, for example:
- £1,350 interest is earned at a 4.5% rate
- After the personal savings allowance is used up and tax applied, this falls to £1,010
- After allowing for 2% inflation, the real gain is just £402
Basic rate taxpayers, who have a bigger £1,000 personal savings allowance, need around £22,000 in a top rate savings account to incur a tax bill. By comparison, additional rate taxpayers pay tax from the very first £1 of interest because they have no PSA at all.
The impact of tax relief on pensions
On a purely numbers basis, when measuring the gains on savings accounts next to pensions, there is really no competition – although you must be willing to lock your money away for a long time.
Pension contributions are one of the most tax-efficient ways to save, for those able to take a longer-term view with their money.
Higher and additional rate taxpayers, in particular, benefit from higher tax relief, giving their contributions a significant immediate boost.
For example, the same £30,000 invested into a pension could lead to a gain after one year of £21,103, according to Standard Life analysis, assuming 5% annual investment growth, 40% tax relief on the whole £30,000 and allowing for 2% inflation.
This is more than 52 times greater than the returns on a taxable cash account, and without any immediate income tax bill.
Pensions are usually taxed as income as they are withdrawn, beyond the 25% tax-free lump sum.
|
Product |
Cost to you |
Value after one year including interest on cash and tax relief on pension |
Value after one year including tax on interest / charges |
Value after one year allowing for 2% inflation |
|---|---|---|---|---|
|
Taxable cash account |
£30,000 |
£31,350 (4.5% interest) |
£31,010 after PSA (£500 tax-free) and £340 tax on the remaining interest |
£30,402 = £402 gain |
|
Cash ISA at 4.5% interest up to £20,000, remaining £10,000 in a taxable cash account earning 4.5% interest |
£30,000 |
£31,350 (4.5% interest) |
£31,350 (interest on £10,000 outside an ISA falls under PSA) |
£30,735= £735 gain |
|
Pension cash account |
£30,000 |
£50,000 after 40% tax relief on the whole £30,000 |
£51,375 (2.75% interest – current base rate minus 1%) |
£50,368= £20,368 gain |
|
Pension Invested |
£30,000 |
£50,000 after 40% tax relief on the whole £30,000 |
£52,125 after 5% investment growth minus 0.75% annual management charge |
£51,103= £21,103 gain |
Source: Standard Life. Inflation calculated on the value after tax on interest and charges for taxable cash account and ISA, and after tax relief, investment growth and charges on the pension. Up to £20,000 each year can be deposited in an ISA.
Ambery, from Standard Life, said: “While ISAs are a solid tax‑efficient option, pensions are where the tax system truly works in your favour. For a higher‑rate taxpayer, a qualifying £30,000 contribution can instantly become £50,000 through tax relief. If you’re planning for the long-term, that head start is incredibly difficult for cash savings to compete with.”
Pensions vs savings: Which is best for my money?
The quick answer is a pension will give you a much higher return on your money than even large sums in some of the best paying savings accounts – although you won’t have access to it in the short-term. But the real answer is, if you can, have both.
A savings account might work better for you if you need access to your cash quickly, for example if it is where you keep your emergency fund. By comparison, pensions are savings for the long term, so you’ll need to be willing and able to tie your money up until at least age 55 (rising soon to 57) before you reap the benefit.