Baremación

Learning Objective

3.1.1 Know the characteristics of fixed term and instant access deposit accounts 3.1.2 Understand the distinction between gross and net interest payments

3.1.3 Be able to calculate the net interest due given the gross interest rate, the deposited sum, the period and tax rate

Nearly all investors keep at least part of their wealth in the form of cash, which will be deposited with a bank or other savings institution to earn interest.

Cash deposits comprise accounts held with banks or other savings institutions, such as building societies.

They are held by a wide variety of depositors, from retail investors, through to companies, governments and financial institutions.

The main characteristics of cash deposits are:

• The return simply comprises interest income with no potential for capital growth.

• The amount invested (the capital) is repaid in full at the end of the investment term or when withdrawn.

Some accounts are known as instant access and the money can be withdrawn at any time; other accounts are for a fixed term, of a year or more. The interest rate paid on deposits will vary with the amount of money deposited and the time for which the money is tied up. Large deposits are more economical for a bank or building society to process and will earn a better rate. The rate will also vary because of competition, as deposit-taking institutions will compete intensely with one another to attract new deposits.

Generally, interest received by an individual is subject to income tax. For most deposits, tax is deducted at source – that is, by the deposit-taker before paying the interest to the depositor. When this happens in the UK, tax is deducted at a flat 20% (regardless of the depositor’s tax rate).

The headline rate of interest quoted by deposit-takers, before deduction of tax, is referred to as gross interest, and the rate of interest after tax is deducted is referred to as net interest.

Example

To keep the calculation simple, let us assume Mrs Jones is entitled to 5% gross interest on £200 deposited in XYZ Bank for a year.

She will earn £200 x 5% = £10 interest on her bank deposit before the deduction of any tax. She will receive net interest of £8 from XYZ Bank. XYZ Bank will subsequently pay the £2 of tax on behalf of Mrs Jones to HM Revenue & Customs.

This can be summarised as follows:

Gross interest earned: £200 x 5% = £10.

Tax deducted by XYZ Bank: 20% x £10 = £2.

Net interest received by Mrs Jones: £10 x 80% = £8.

For a basic rate taxpayer, the tax deducted at source means that no further tax is payable. For a higher rate taxpayer, liable to tax at 40%, a further 20% will have to be paid when she submits her tax return.

Those with incomes over £150,000 are liable to the additional rate of tax at 45% (in 2014–15) and will pay a further 25% over the basic rate.

Non-taxpayers, such as those on very low incomes, can submit a form known as an ‘R85’. This is submitted to HM Revenue & Customs (HMRC) and once approved enables interest to be paid gross, with no deduction of tax at source. This is much easier than having tax deducted at source and filling out and submitting a tax reclaim form.

At the end of the tax year, depositors receive a tax certificate from the savings institution which confirms that the basic rate of tax has been paid on their behalf.

Exercise 1

Mr Evans is a basic rate taxpayer. He has had £3,000 on deposit at XYZ Bank for a year, earning 4% gross interest. How much interest does Mr Evans receive, and how much is deducted at source on his behalf?

Exercise 2

Jayesh is 12 years old and his father has submitted an R85 form on his behalf. Jayesh has had £400 on deposit at XYZ Bank for a year, earning 3% gross interest. How much interest does Jayesh receive, and how much is deducted at source on his behalf?

The answers to these exercises can be found at the end of this chapter.

3

2.1 Advantages and Disadvantages

Learning Objective

3.1.4 Know the advantages and disadvantages of investing in cash

There are a number of advantages to investing in cash:

• One of the key reasons for holding money in the form of cash deposits is liquidity. Liquidity is the ease and speed with which an investment can be turned into cash to meet spending needs. Most investors are likely to have a need for cash at short notice and so should plan to hold some cash on deposit to meet possible needs and emergencies before considering other less liquid investments.

• The other main reasons for holding cash investments are as a savings vehicle and for the interest return that can be earned on them.

• A further advantage is the relative safety that cash investments have and that they are not exposed to market volatility, as is the case with other types of assets.

Although cash investments are relatively simple products, it does not follow that they are free of risks, as 2008 so clearly demonstrated. Investing in cash does have some serious drawbacks, including:

• Deposit-taking institutions are of varying creditworthiness; the risk that they may default needs to be assessed and taken into account.

• Inflation reduces the real return that is being earned on cash deposits and could mean the real return after tax is negative.

• Interest rates vary and so the returns from cash-based deposits will also vary.

• There is a currency risk, and different regulatory regimes to take into account, where funds are invested offshore.

As a result, when comparing available investment options it is important to consider the risks that exist as well as comparing the interest rates available.

Bank and building society deposits are usually protected by a compensation scheme. This will repay any deposited money lost, up to a set maximum, as a result of the collapse of a bank or building society.

The sum is fixed so as to be of meaningful protection to most retail investors, although it would be of less help to very substantial depositors. It should also be noted that cash investments are not a ‘designated investment’. As a result, they do not fall within the scope of the Financial Services and Markets Act 2000 (FSMA), with the exception of money market funds and Cash NISAs. Although most cash products are not regulated, the Prudential Regulatory Authority does regulate banks and other deposit-takers, and depositors based in the UK are covered by the Financial Services Compensation Scheme (FSCS). The FSCS provides protection for the first £85,000 of deposits per person with an authorised institution.