Boost Your Cash Earnings: Over 4% with a Stocks and Shares ISA

Chancellor’s Potential Cuts to Cash ISA Limits Stir Concern Among Savers

As speculation grows regarding potential changes to the cash ISA limit, millions of savers are left apprehensive about the implications. Recent discussions suggest that Chancellor Rachel Reeves may consider reducing the cash ISA allowance significantly, possibly to between £4,000 and £5,000. At present, individuals can invest up to £20,000 annually into a cash ISA, enjoying the benefit of tax-free interest.

Implications of a Reduced Cash ISA Allowance

If the cash ISA limit is indeed slashed, many savers could find themselves facing tax liabilities on the interest earned from their savings. Higher earners in particular could see a substantial portion of their interest—up to 45%—taken by HM Revenue and Customs (HMRC). This situation has led to widespread concern among individuals who rely on cash ISAs to shield their savings from taxation.

However, there is a silver lining for those anxious about these potential changes. Savers can still achieve tax-free, cash-like returns without relying solely on cash ISAs. One alternative is to invest in a money market fund within a stocks and shares ISA, which can currently offer yields exceeding 4% or even 5%.

The Rise of Money Market Funds

Mark Burges Watson, co-founder of the financial app Kaldi, highlighted this approach, stating that if the Chancellor cuts the cash ISA allowance, many savers would be left pondering what to do with the remaining tax-free allowance. He suggests that money market funds offer a viable solution that is not yet widely discussed.

Since interest rates have risen after a prolonged period of low returns, money market funds have gained considerable popularity. These funds provide a practical alternative for those seeking stable returns, particularly in light of the current uncertainty surrounding cash ISA limits. Notably, the Fidelity Cash Fund has emerged as the best-selling fund of the year, while the Royal London Short Term Money Market has dominated the list of the most-purchased funds for over six months on investment platforms like Interactive Investor.

Understanding Money Market Funds

So, what exactly are money market funds? Also known as cash funds, these investments can be held within a stocks and shares ISA, pension, or general investment account. They are designed to be low-risk and typically track UK interest rates, making them akin to traditional savings accounts or cash ISAs.

According to Andrew Prosser, head of investments at InvestEngine, money market funds primarily consist of short-term debt from governments, banks, and corporations with strong balance sheets and investment-grade credit ratings. As a result, they can offer relatively stable—if slightly lower—returns compared to other investment types, with the added benefit that returns invested through an ISA are tax-free.

Potential Earnings from Money Market Funds

Investors can expect to receive income from money market funds, commonly referred to as the yield. Although this yield is not guaranteed and can fluctuate, current offerings appear promising. Laith Khalaf, head of investment analysis at AJ Bell, noted that several money market funds are currently providing “decent yields.” The top five money market funds among DIY investors on the AJ Bell platform are:

• Abrdn Sterling Money Market: Historic yield of 3.9%
• Fidelity Cash Fund: 4.8%
• Legal & General Cash: 4.8%
• Royal London Short Term Money Market: 5.3%
• Vanguard Sterling Short Term Money Market: 4.7%

It is important to note that these yields reflect historical performance and are variable; thus, they may not be replicated in the future, especially with the possibility of declining interest rates.

The Risks Involved with Money Market Funds

While money market funds can be a suitable alternative to cash ISAs, they are not without risk. The yield can decrease, and in some cases, returns may turn negative. Khalaf pointed out that during periods of low interest rates, some funds have reported negative returns when fees outweighed the minimal interest earned.

Furthermore, during the financial crisis, the value of certain money market funds fell significantly due to uncertainty surrounding the solvency of banks. Although this was an unusual occurrence, it led to stricter regulations designed to mitigate such risks in the future. Burges Watson emphasised that while many institutions back their money market funds to absorb minor losses, these funds do not benefit from the £85,000 government guarantee provided by the Financial Services Compensation Scheme, which is applicable to savings accounts and cash ISAs.

Utilising Your ISA Allowance

Savers can allocate their entire ISA allowance to one or multiple money market funds if they choose. Alternatively, if the cash ISA limit is reduced, individuals could still maintain their cash ISA at the new maximum level and use their stocks and shares ISA to invest any remaining allowance in money market funds.

It is essential to consider that for those looking to grow their wealth, investing in the stock market—through shares or equity funds—may yield higher returns, albeit with increased risk compared to cash and money market funds.

Exploring Cash Investment Options in Stocks and Shares ISAs

For investors who prefer to keep their funds in cash before making investment decisions, most platforms allow users to “park” their money in cash. This option enables new investors to earn interest while contemplating their investment strategies. Interest rates on cash balances can differ significantly across platforms, with some offering rates as low as 1% or 2%, while others, such as AJ Bell’s Dodl ISA, provide more competitive rates around 4.32%.

In summary, while the potential reduction of the cash ISA limit may cause concern among savers, alternative investment avenues like money market funds offer viable options for generating tax-free returns. Savvy investors can navigate these changes by exploring various investment strategies that align with their financial goals.