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We Need UK’s Individual Savings Accounts

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The UK just joined us i experiencing a phenomenon known as a “negative real interest rates,” where the rate of their central bank is less than the rate of inflation. The Bank of England’s base rate stands at 4.5% and their recent calculation of inflation puts it at 5.2%, meaning savers are seeing their savings erode at 0.7% a year. The Federal Reserve, the United States’ central bank, current set its target interest rate to 1.5% with inflation, especially if you don’t use the bogus sans food/fuel measure, being much much higher.

The economic climate has made it wrong, financially, to save money!

Individual Savings Accounts

One of the ways UK citizens can combat this is to use what’s known as an individual savings account, a type of account unavailable to us here in the United States. Individual savings accounts can get pretty complicated but the part that I find intriguing is that it incentivizes saving, something we Americans have a difficult time doing.

The ISA has two components, a cash component and a stocks and shares component. Without getting too deep into its inner workings, especially since I have no hands on experience with it, the part that I like and feel we need is the cash component. Each year, eligible persons can contribute up to £3,600 into the cash component and the interest earned is tax free. (The stocks and shares portion has a higher limit but all the income derived from that component are also tax free). I admit that I might not know all the details about ISAs, but at first glance they are very appealing.

We have nothing like this here.

We Need That Cash Component

Given the availability of Traditional and Roth IRAs, I don’t think introducing the stock and shares component of the ISA would add much (though brokers would probably love it!) but the cash component is something we should think about.

Imagine if some of those high yield savings accounts offered tax free savings accounts, like these ISAs. The prevailing rate of 3.50% APY at FNBO Direct would be the equivalent of 4.67% APY for someone in the 25% tax bracket.

We need to start incentivizing people to save, rather than incentivizing people to spend. The economy may be hurt in the short term but will be greatly strengthened in the long term.

What do you all think?

{ 15 comments, please add your thoughts now! }

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15 Responses to “We Need UK’s Individual Savings Accounts”

  1. Anoym says:

    Jim,

    I think that’s a great idea. Actually, I was chatting with my boss the other day during the lunch break, and I raised exactly the same point: one thing that may encourage people to start saving is to give them some incentives, such as treating interests earned on savings as tax-free income. By taxing the interests on savings, the IRS is essentially punishing people who actually care about their own finance (hence less dependent on the society if there is a crisis). Sure, it helps the economy if people spend more, but in the long run, this is not sustainable — a lot of people are actually borrowing into the future with negative savings rates. You are right, in the short term, the IRS may collect fewer tax dollars, but it help in the long run. Unfortunately, I don’t see those government officials don’t care about the long-term sustainability of the society.

  2. Gates VP says:

    As a Canadian transplant to the US, I’m honestly not a big fan of the US system. (especially the 401k).

    Check out Canada’s RRSP (Registered Retirement Savings Plan) for a cleaner implementation of the 401k. (We also have allowances for Education, rEsp)

    They’re also rolling out a TFSA (Tax-Free Savings Account) that is similar in concept to the Individual Savings Account.

    Check out milliondollarjourney and Quest for the Four Pillars as they have several posts related to the new TFSAs as well as to comparing the US / Canadian systems.

  3. Patrick says:

    That is an awesome idea. What I don’t get about this country is that everybody is about spending, including our government. The Maryland government is trying to cut back spending now by trimming stuff off the budget and present it to the media like it’s a horrible thing. It makes sense that the people in our country are not savers if our government acts the same way.

  4. I wish people could be better savers. Though you know people never like to be sold but the do like to buy. It all comes down to education. People who are educated about money will tend to do better than those who learn to just spend everything they have.

  5. Fred says:

    “The economy may be hurt in the short term but will be greatly strengthened in the long term.”

    Amen. This type of an account is a great idea, and gives relief to the middle class (something both candidates are eager to do these days).

  6. CK says:

    Hey what if we just stopped taxing interest income? What a crazy plan! We give people tax breaks for borrowing money (home interest, which with home equity lines people used for everything under the sun), why not give them a “tax break” for saving?

  7. Rob Lewis says:

    Yes, our ISAs are quite a nice product, and cash ISAs in particular are very popular over here, although probably not as popular as they should be, given that they allow you to grow your money without giving any to the tax man. Definitely gives some good encouragement to save, it’s just a pity the allowance for cash ISAs (£3,600 as you rightly point out) is so small.

  8. Miss M says:

    It sounds like a start at least, I also think it’s crazy how our government discourages traditional saving and encourages us to gamble our money on the market. If I gain $100 in interest I have to pay taxes at 25% or more versus the 15% capital gains tax if I make $100 on a stock.

  9. Tim says:

    we have plenty of tax-exempt vehicles.

  10. Gates VP says:

    @CK: Hey what if we just stopped taxing interest income? What a crazy plan! We give people tax breaks for borrowing money (home interest, which with home equity lines people used for everything under the sun), why not give them a “tax break” for saving?

    The truth is, giving a tax break on borrowing money for a home is economically questionable. See here and here and here for some discussion about the situation. I don’t know that you want to compare that tax to a tax on interest income.

    The big question you’re asking is: … what if we just stopped taxing interest income?. The simple answer is that the government needs those tax revenues, so it definitely won’t happen tomorrow.

    The more complex answer has to do with longer term effects of such a decision. Right now the British and Canadian systems have caps. An individual cap at say $5,000 means that middle-class investors can benefit from the growth without killing government revenues from top investors.

    If you don’t provide some type of cap, then you’ve not only lost revenue, but you’ve just opened up a giant loop-hole.

    Instead of making 50k, I’d make 25k at a lower income tax bracket and get company bonds that pay out bi-weekly tax free money to make up the other 25k :) . Long-term people would funnel all of their money into some form of “interest-generating” income to avoid the tax-man.

    Removing the capital gains tax would be a mess.

    On a grander scale, there’s also a limit to the amount of savings that an economy can endure without suffering negative side effects.

    Sure this isn’t evident in the US, but it’s killing China. Average personal savings are 25%+ of income. With too much money sitting around in bank accounts, nobody earns any interest, who needs to borrow money if everyone has money in the bank? The side effects from this are a whole post unto itself.

  11. CK says:

    @Gates VP

    I didn’t mean to suggest I thought the home mortgage interest deduction is a good idea. I don’t think it is.

    “Instead of making 50k, I’d make 25k at a lower income tax bracket and get company bonds that pay out bi-weekly tax free money to make up the other 25k :) . Long-term people would funnel all of their money into some form of “interest-generating” income to avoid the tax-man.”

    What your describing is called a tax shelter and easily made illegal.

    Also I’d like to know where the 25%+ savings stat from China came from.

  12. Gates VP says:

    @CK

    Some details on China are available here (CNN money 2006), here (NPR Marketplace, Feb 2007), here (Shanghai Daily, 2007). A quote from the first link: Thrifty Chinese have taken saving to excess, while profligate Americans have spent their way into debt…Neither of these trends is sustainable — they lead to destabilizing economic and political developments for both nations — and a better balance must be struck.

    @CK: What your describing is called a tax shelter and easily made illegal.

    Are you suggesting that you could illegalize a company providing stock as a form of payment to its employees? Doesn’t this sound like pretty dicey territory?

  13. CK says:

    @ Gates VP

    You said people would funnel their money into “interest-generating” income. I’m no expert but I’m pretty sure stocks do not generate interest.

    As well most employers are not publicly traded so have no stock to issue.

  14. Gates VP says:

    @CK:I’m no expert but I’m pretty sure stocks do not generate interest.

    Stocks can generate dividends which are taxed in a similar fashion. You could replace “stocks” with bonds that pay out monthly instead. The purpose here would be the same: “replace highly taxed income with low-taxed paper”.

    @CK:As well most employers are not publicly traded so have no stock to issue.

    Companies do not need to be publicly-traded to issue stock.

    Now honestly, something like what I’ve suggested could likely be done today. In a live airing of IOUSA Warren Buffet commented that he paid about 15% tax on his earnings, but the lady who cleaned his office paid 15.5%.

    Right now nobody “cheats” b/c it’s just not a big enough deal. No employee is running around asking to be paid differently b/c the overhead and headaches of issuing “internal bonds” just isn’t worth the trouble. You’d be talking thousands of dollars of legal work to save hundreds in taxes for the average person.

    But imagine a world where the interest was untaxed? You’ve now massively dropped the “barrier to entry”. Lawyers and accountants would pop up within weeks all providing ways that employers could provide more money to employees by reducing their tax load.

    It may not happen overnight, but all eyes would be pointing at “interest income” as the “one true way to make money”. And it would be, the zero tax rate would be the government sanction that this was the way to go.

    My point is simply that by reducing the tax on “interest income” to zero, you’re creating a giant hole. It’s one thing to tweak the tax rates to encourage or discourage certain behaviors, but dropping the tax rate so dramatically would simply be chaos.

    Back to the original premise: Hey what if we just stopped taxing interest income? What a crazy plan!

    it is a pretty crazy plan. But letting people set aside reasonable sums of money that can grow tax-free isn’t all that crazy.

    @Tim: We have plenty of tax-exempt vehicles.

    And we probably have too many. Moving to a system with two tax-exempt vehicles would likely be enough and I’d include something like the ISA as one (and a better version of the 401k as the other).

  15. AverageJoe says:

    In light of what’s happening in banking recently, with most big banks being undercapitalized, getting individuals excited about saving money in a bank would be a fantastic idea.

    People could have a savings account with no taxes on interest income (up to a cap, as stated above) instead of everyone buying US Treasuries (with yields close to zero anyway) so that the government can give out TARP money to the banks to shore up their balance sheets. The cash component of the ISA would take the government out of it, and the citizen’s money would go directly to the banks.

    Of course, this makes too much sense, right? Why pick a simpler solution when a more complex one will do……


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