Don't miss out on tax-free savings

Many people are missing out on an opportunity to earn an extra 23 per cent on their savings

The bank and building societies know that a fractional difference in the interest rate they pay can spell defeat or victory over a competitor. But while savers chase high rates on savings accounts, many pass up an opportunity to earn an extra 23 per cent on their money with a cash ISA - the government's tax-free savings vehicle.

The bank and building societies know that a fractional difference in the interest rate they pay can spell defeat or victory over a competitor. But while savers chase high rates on savings accounts, many pass up an opportunity to earn an extra 23 per cent on their money with a cash ISA - the government's tax-free savings vehicle.

ISAs, or Individual Savings Accounts, were introduced at the beginning of the last tax year. You can use them to invest in stocks and shares and insurance, as well as cash. The cash part can either be as part of a maxi ISA - where all three elements of the account are held with the same provider - or as a mini cash ISA, which stands alone.

Mini cash ISAs are simply deposit accounts which pay tax-free interest. So whereas with a standard deposit account, a taxpayer would normally have tax on the interest earned deducted at source, the interest is received gross in an ISA.

There are limits on how much you can put into an ISA in any one tax year. For the cash portion of the ISA, the limit this year is £3,000 - the same as last year. But next year, this threshold is set to fall to £1,000. Mini cash ISAs are fairly straightforward financial products. So how do you choose?

The interest rate is the first thing to look at. Most mini cash ISAs pay at least 6 per cent, but some pay as much as 7.3 per cent. Consider the strength of the provider too, says Kim North of IFAs Culkin Pattinson. Some ISA providers offer high interest rates for a short period in order to win business, but then drop the rate a few weeks later.

Some ISAs are CAT-marked, which means they meet Government Conditions, Terms and Access standards. A mini cash ISA can only win a CAT mark if it allows you to, for example, withdraw money without giving notice. But some ISAs which do not qualify offer higher rates of interest because you have to tie your money up for a set period. "Don't get too caught up looking at CAT standard accounts," says Justin Modray of independent financial advisers Chase de Vere. "A lot of cash ISAs don't have a CAT mark, but that doesn't mean they're not good."

If you can afford to give three months' notice before withdrawing funds, Julian Hodge Bank offers 7.3 per cent interest on its mini cash ISA, according to financial data provider Moneyfacts. This account has no CAT mark. Other accounts forgo the CAT mark because they have additional conditions, perhaps requiring a minimum deposit of the full £3,000 ISA allowance.

You should look at the conditions of an account before investing. The interest rate offered may look higher than it will be in the long-term if the institution is paying a one-off bonus. This, says Mr Modray, is a crafty marketing invention which gets the account into the best-buy tables temporarily. If you do opt for this incentive, make sure you are free to move your money away when the bonus has been paid.

So watch out for accounts which charge a penalty for transferring your ISA to another provider. Cheltenham & Gloucester and West Bromwich Building Society, for example, charge £30 to do this.

The vast majority of cash ISAs pay interest at a variable rate which will fluctuate roughly in line with Bank of England rates. But, most cash ISAs which lock your money away for a year or more pay a fixed rate of interest. Fixed rates give you more security, although some economists believe UK base rates have further to rise.

Before taking out a mini cash ISA, you should consider whether you are likely to make use of the stocks and shares element of that year's ISA allowance. By opening a mini cash ISA, you effectively limit the amount of your share-based investment that tax year to £3,000, which is the ceiling for a mini equity ISA. With a maxi ISA, your limit would be £7,000 but the interest paid on the cash portion of a maxi ISA tends to be less.

Fund management group Fidelity offers a wide range of funds in its maxi ISA, but only pays 4.8 per cent interest on cash. Virgin Direct pays the same rate of interest for cash in its maxi ISA as it does in its mini cash ISA - 5.5 per cent. The disadvantage is that Virgin only offers a choice of two investment funds for the equity portion of the maxi ISA. Among mini cash ISAs, Smile, the online bank owned by Cooperative Bank, offers the highest rate paid on an instant access account at 7.25 per cent interest on balances from £1. "If you are IT-familiar, you should consider Smile," says Ms North.

Culkin Pattinson: 020-7734 9899

Chase de Vere: 01225 469371

Smile: www.smile.co.uk

Julian Hodge Bank: 0800 0283746

Virgin Direct: 08456 102040

Fidelity: 0800 414171

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