I have received a £25,000 lump sum from an inheritance. I’m wondering what to do with the cash which is now sitting in my bank account earning zero interest. I don’t see myself needing to use the money for the foreseeable future, so I’m looking to grow it without being reckless.
I already hold almost £10,000 in an easy-access savings account earning 2.5 per cent, which is effectively my financial safety net in case I lose my job. I also hold some investments in an Isa through an online investing platform, but these have done really badly over the past year.
I have seen that I can get a 4.6 per cent on a five-year fixed rate savings bond. This seems like a great way to guarantee a decent return without putting the capital at risk. Or am I missing something?
What to do? Our reader is wondering whether a five year fixed rate savings deal could be a safer way to grow their wealth than investing
Ed Magnus of This is Money replies: You are prudent to consider how best to grow this £25,000 windfall. Inaction will cost you.
Doing nothing will see the value of that £25,000 falling in real terms due to inflation running at levels not seen in 40 years.
Inflation rose to 10.4 per cent in the 12 months to February. This means what £25,000 could have bought you a year ago, will now typically require £27,600 today. That’s effectively a £2,600 loss in real terms.
Although inflation is expected to fall this year, its eroding powers should always act as a reminder of why it’s important to either invest or save with a decent return in mind.
Saving in cash not only provides a known return and security, with deposits protected from up to £85,000 by the Financial Services Compensation Scheme.
A fixed rate savings bond will typically offer the best returns and you have spotted one of the best five-year fixes paying 4.6 per cent.
Whacking £25,000 in this account will earn you £6,304 of interest over the five year period.
However, it’s also possible to get a similar rate and fix for a shorter time period. The best one-year fix pays 4.5 per cent and the best two-year fix pays 4.62 per cent.
The problem with fixing for so long is that there is no escape route. Typically no withdrawals are permitted before the end date.
Many providers simply state that no withdrawal is possible, while some make it clear that access will only be granted in exceptional circumstances, such as the death of the account holder or a life threatening illness.
You should therefore only put money into a fixed account if you definitely don’t need to access during the term – and five years is a long time.
Locked up: Once in a fixed rate savings account, the money typically cannot be accessed until the end of the fixed rate term
Investing is another option, given you have no intention of spending the money in the foreseeable future. Although there is always risk, it does tend to deliver higher returns than saving over the long term.
Barclays Equity Gilt Study 2022 showed that in the decade to the end of 2021, investing in the UK stock market (equities) delivered an average annual real return of 4.7 per cent, whereas cash produced a -2.5 per cent real return.
Investing should also give you more flexibility than fixed rate savings as you can usually sell investments if needed.
Investing using your Isa or through a self invested personal pension (Sipp) also has the added benefit of any income or gains being tax free.
The Barclays Equity Gilt Study 2022 shows different long-term returns after inflation
Finally, there are tax implications to consider. Fixed rate savings deals typically either pay interest out annually or monthly, or at maturity (when the term ends).
You can typically either have the interest paid into another account or have the interest added to the fixed account itself, which will benefit from added compounding.
The problem with the latter approach is that it can end up being a tax trap. This is because the interest becomes taxable at the point it becomes accessible.
HMRC states: ‘Interest “arises” when it is received or made available to the recipient. Interest has been made available if it is credited to an account on which the account holder is free to draw.’
If the terms and conditions allow the saver to withdraw their funds, albeit even with a penalty incurred, the interest is in fact taxable in each year it is credited.
However, if the terms and conditions do not allow access until maturity (the end of the full term), the interest can only be taxed at that point.
The latter scenario is the most common. Some building societies permit access with an interest penalty, but most of the major fixed providers don’t allow access.
This means if you receive interest in one go at the end of the term, you could end up with a much larger tax bill – unless there is a provision to escape the fixed rate deal. So you need to check the terms and conditions before committing.
Basic rate taxpayers get an annual savings allowance of £1,000 tax-free. Everything above that will be taxed at 20 per cent. Higher rate taxpayers get a £500 allowance, with everything above that taxed at 40 per cent.
To provider further advice, we spoke to Andrew Hagger, a personal finance expert at Moneycomms, Tom Parry, chartered financial planner at Old Mill, and Laura McLean, chartered independent financial advisor at The Private Office.
Think about how you might use the cash in the future
Tom Parry replies: You need to consider what you want to do with the funds at the end of the five-year period.
If they are likely to be ‘rolled over’ into another cash account or reinvested, then you have, in effect, a longer time horizon. So erring towards an investment of sorts might be the way to go.
However, if there’s a chance you’ll need funds at maturity – to put towards house deposit, for example, or to pay off a debt – then the capital stability offered by a cash holding could be preferable.
The rates available on a bond are attractive, but you won’t be able to access your funds for a period of time.
Andrew Hagger adds: While 4.6 per cent is the best rate of return on fixed rate cash savings at present, it’s worth double-checking whether locking your cash away until Spring 2028 is the most suitable option.
Your circumstances could change in the next five years, and you may regret locking the full £25,000 away for that length of time.
You say you have £10,000 in easy-access monies for emergencies or temporary unemployment, but if the latter occurred you may also want access to some of that £25,000 pot.
Rates on shorter fixed terms are not much lower – for example you can currently get 4.51 per cent for 2 years and 4.55 per cent for three years.
Consider the tax implications
Andrew Hagger replies: The other area to consider is the tax implication of £25,000.
A bond paying 4.5 per cent annually will generate £1,125 in interest income. This is above the annual personal savings allowance of £1,000 for basic rate tax payers or £500 for higher rate tax payers.
Therefore, it makes sense to shield some of this cash savings pot from the tax man by putting some of it in a cash Isa, which is tax free up to a maximum of £20,000 per annum.
Cash Isa rates are slightly lower than with standard savings accounts, but you can still earn a respectable 4.15 per cent for a one-year fix with Santander at present.
Consider a shorter fix
Anna Bowes, co-founder of SavingsChampion says: ‘With shorter term bonds paying not that much less, if you do choose the cash route, you may not need to put all of your cash into a five-year bond.
‘The top one-year is currently paying 4.48 per cent, the top three-year is paying 4.55 per cent and as you mentioned the top five-year rate is paying 4.6 per cent.
‘Even better, if you were to choose a Sharia-compliant fixed term bond, you could earn even more over the shorter term.
You can currently earn 4.5 per cent for one-year and 4.68 per cent for three-years.’
Andrew Hagger replies: Spreading your £25,000 across a number of fixed rate bonds and fixed Isas of differing terms would give you more flexibility and keep your savings income free of tax.
For example £10,000 in a one year Isa, £7,500 in a two-year bond and £7,500 in a three year bond still generates a good rate of interest, but by adopting this strategy you have savings balances maturing every 12 months for the next three years which gives you more choices and flexibility.
Also consider whether you want the interest to be paid monthly should you wish to supplement your income.
Should they save or invest the money?
Laura McLean replies: An emergency fund and short-term spend safety net should always be kept in cash, to avoid the risk of being a forced seller at the wrong time – such as when investment markets fall.
Provided your safety net of £10,000 is sufficient for this, and you don’t expect to need access to the inheritance for at least five years, investing can be a suitable option to provide opportunities for more attractive long-term growth.
You do need to be comfortable with bumps in the road along the way though, as you have already seen with your invested Isa, and a longer-term outlook should see these bumps smoothed-out over time.
A diversified mix of asset classes, such as equities, fixed income, and possibly alternative assets such as commodities, as well as investing globally can be sensible so that you are not dependent on the performance of assets in just one country or type of investment.
Choices: Investing is another option, given our reader has no intention of spending the money in the foreseeable future
Tom Parry adds: It really depends on the level of risk you are comfortable with – do you want to hold funds in cash or to embrace an element of investment risk?
The advantage of cash is that you’ll receive a decent interest return and capital stability.
However, that return is unlikely to match inflation based on current predictions, so the ‘real’ value of your funds – their purchasing power – will diminish.
There’s also no guarantee that rates will stay where they are now and if they rise in future, you’ll be unable to access a higher rate if you’ve fixed for a period of time.
Given you’re looking at a five-year period, you have sufficient time to invest if you want to. If you do so, the funds have the potential to grow in line with – or even above – inflation over the period.
But there is no guarantee that the capital value of your funds will outperform the equivalent return available from a fixed-rate bond. And of course, as with any investment, the value could also fall.
Avoid the fixed rate tax trap
A spokesperson for the Savings Guru says: ‘Some fixed term savings providers pay monthly interest and many pay annually.
‘However, there are plenty of providers who either give the option, or make it the only option, to have interest added to the bond.
‘It’s when the interest is available to the saver that it becomes taxable – not the annual interest statement.
‘So if you choose to have annual interest added to the bond, or interest paid at the end of the term, HMRC will record the interest at that point.
‘For example, £25,000 saved at 4.6 per cent earning £1,150 per year which is added to the bond will mean that £5,750 (ignoring compounding) is reportable to them on maturity, not £1,150 each year.
‘In this scenario savers will not be able to use their personal savings allowance each year to lower the tax burden.’
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