Why cash ISAs will be 'merged' with popular savings account, expert says

The Chancellor of the Exchequer Rachel Reeves has said she wants savers to get better returns on their savings and her comments have ignited speculation she could merge with their stocks and shares counterpart. Ms Reeves was asked whether she planned to reduce the £20,000 annual allowance for ISA savings which currently alllows savers to split their £20,000 allowance between the different types of ISA.

Ms Reeves told the BBC she was not going to reduce the limit on what people can put into an ISA but added that she wants people to get better returns on their , whether that's in a pension or their day-to-day savings. She said: "At the moment, a lot of money is put into cash or bonds when it could be invested in equities, in stock markets, and earn a better return for people."

Ed Monk, an associate director at Fidelity International, said Ms Reeves comments leave open the possibility that action may be taken to reform ISA rules.

He said: "That could mean a reduction in the allowances for cash ISA savings while maintaining the overall £20,000 ISA limit.

Mr Monk said Fidelity International had called for cash and ISAs to be merged into one single ISA, thereby removing the barrier of having to move money between products or providers when managing savings.

Other changes could happen to reduce the impact of limiting tax-free cash savings.

Mr Monk said the government could expand the Personal Savings Allowance - the sum that you can earn in interest each year before tax is due. "Currently, basic rate taxpayers can earn £1,000 of interest outside an ISA before tax is due. Higher rate payers can earn £500 while Additional rate payers have no Personal Savings Allowance at all."

He said Ms Reeves could also change the 'starting rate for savings' which allows those with other income below £17,570 to earn extra amounts of interest without tax. As much as £5,000 of tax-free interest each year is available for those in this position.

Previous suggested changes to the system include applying a limit to the amount that can be held in ISAs. For example, the Resolution Foundation, a think tank, has argued for ISA wealth to be capped at £100,000.

If any changes are made, Mr Monk said it was likely to be in the autumn budget.

He said: "Based on previous experience, changes to tax rules for savings have not been made retrospectively - meaning new rules would apply only to money contributed after the rule-change is enacted. Money that is currently sheltered from tax is unlikely to be suddenly exposed to it."

Monk said it makes sense to encourage more cash savers to invest as a means of improving their own financial prospects in the long-term. That's because returns from investments have tended to beat returns from cash - as shown below - albeit with the risk of loss along the way.

"Additionally, the Government has made clear its desire to get the economy growing more quickly and has identified the UK's role as a financial hub in achieving that. It therefore makes some sense to encourage savers to put money held in cash to use in stocks or bonds, where it can potentially be more productive. This could also increase domestic demand for shares, adding to the appeal of the UK to companies looking for a market on which to list their shares.

"Advocates of limiting Cash ISAs have argued that no other country incentivises people to park their money in cash.

"Finally, there could be an attraction in removing tax-free status from cash interest as a means to raise tax revenue. "

Why the Government might not change Cash ISAs

He said: "Ending Cash ISAs would be very unpopular with those savers who currently enjoy the tax-free returns they offer. These might include people who do not want to risk losses from investments, and perhaps those in retirement who do not have long time horizons, which can help reduce the risk of sudden investment losses."

"The government will also be wary of making any changes that adds to the tax advantages of the wealthy."

Which is best - cash ISA or stocks and shares ISA?

Mr Monk said cash and investments both play an important and different role in your financial mix. "One isn't inherently better than the other.

"It makes sense to hold a sum of cash that you can dip into in an emergency - an amount worth three to six months of income is recommended. Money after that could be considered for investing.

"Building some emergency cash first can actually help your investing because it means you are better able to leave investments alone. You won't have to sell them to produce cash in a pinch at a time not of your choosing. It can also make sense to hold cash on the sidelines that you are willing to use to take advantage of investment buying opportunities as they arise.

"Cash will not lose value in nominal terms (although it can lose value to inflation), whereas investments can fall in value.

"The compensation for taking that risk is the potential that investments can produce a higher return, with the chance, of course, that they don't."

The chart below helps to make the point. It shows the performance of global shares versus assets that produce a cash-like return going all the way back to 1999. While there have been periods when investments have fallen in value and you would have been better off in cash, the long-term outperformance of investments is clear.