Does Santander 123's 3% interest beat a cash ISA?

It's yet to be seen how powerful this tax year's cash ISA season will be as the new much bigger £15,000 limit (this will rise to £15,240 on 6 April) means fewer people are able to fill up their ISA allowance, so there's less urgency.

More interestingly, there's also the rather strange fact that while the top easy-access cash ISA currently pays just 1.5% (slightly higher than the top normal savings accounts at 1.41%), a range of current accounts pay far higher rates – banks offer these as loss leaders to draw in customers to switch. No surprise then that my Twitter feed and email inbox is full of people asking about it, the most prevalent question being: "Should I save in a cash ISA or in Santander's 123 current account?" And it's a very legitimate question. I'm a fan of the Santander 123 bank account as while others pay higher interest than its 3%, it allows you to save up to £20,000 at the high rate. It does have a £2 per month fee, but as it pays cashback on direct debit bills you pay out from the account, for most this is easily covered (and some are earning £5-£10 extra a month).

The current account paying the highest interest on the next largest amount is Club Lloyds, which pays 4% but only on £4,000-£5,000, followed by TSB at 5% but only on up to £2,000. (Nationwide pays 5% on up to £2,500, but only for a year). For a full review and breakdown of these, see our 5% savings loophole guide. The answer, however, is not a straightforward yes or no, so I want to take you through it…

Two quick thoughts before I start

If you are looking for somewhere to put cash in total safety (as opposed to taking a risk with investing, which is an entirely different decision) there are two things to consider before saving:

• Have you got expensive debts? If so it's worth paying them off before saving, as they cost far more than you'd earn by saving. If this goes against the grain as you'd "like to have some cash set aside", then read Should I repay debts with savings?, where I explain how this can be a dangerous mentality.

• Have you got a mortgage? If so and your mortgage rate is higher than the after-tax interest you can get by saving, then it can be worth paying that off instead. Read my Should I overpay my mortgage? guide for more and try the mortgage overpayment calculator.

Right with that said, let's get on to the core question…

Santander 123 v easy-access cash ISAs

I'm going to focus on the Santander 123 at 3%, yet similar logic applies to the other higher paying accounts for smaller amounts. Of course with all of them, unless you play games (see 5% savings loophole) you have to be willing to switch bank account to get them.

• On rate, Santander smashes easy-access cash ISAs

  Bank accounts of course allow 'easy-access' – in other words, you can take your money out whenever you want. The interest generated on money in bank accounts is taxed just like normal savings, so you lose 20% of it as a basic-rate taxpayer, 40% higher rate, 45% for additional rate. Therefore as Santander's pre-tax interest rate is 3% AER, a basic-rate taxpayer actually receives 2.4% after tax, a higher-rate taxpayer 1.8%, and for an additional-rate payer (those earning above £150,000) it's 1.65%. With Club Lloyd's at 4%, a basic-rate taxpayer gets 3.2%, higher rate 2.4%, top rate 2.2%. With TSB at 5% a basic-rate taxpayer gets 4%, higher rate 3% and top rate 2.75%.

  Of course save money in a cash ISA and as it is tax free, you don't lose any of your interest. Yet even taking that into account the best easy-access ISA account pays just 1.5% – so the bank accounts still leave you with more even after tax.

• Santander 123's rate may not last forever

  Santander 123 and the other bank accounts' interest rates are 'variable', which means they can be changed both due to interest rate moves or simply at the banks' whim.

  Yet Santander's account has been incredibly successful for the bank, so I think severe changes are unlikely in the short-term. However, I doubt this loss-leading deal designed to encourage people to churn bank accounts will still be paying double the best easy-access savings rate in a few years' time, which is why the next point is important to consider…

• Putting money in a cash ISA has a long-term gain

  Easy-access cash ISA rates are of course variable too. Yet the gain of putting your money in an ISA now means it's not just tax-free this year, it remains tax-free year after year. So even if your provider's rate drops, you can do a cash ISA transfer to shift it to a different account and retain the boon of its tax-free status. And as you get a new allowance each year, you can, over time, protect an ever greater sum from the taxman. At some point it's likely UK interest rates will rise again and when they do cash ISA returns will be greater, and at that point having a large chunk of your savings protected from tax will be a big boon. Update: 31 March 2015: The new personal savings allowance due to start in April 2016 will mitigate this gain somewhat as it will allow basic rate taxpayers to earn £1,000 worth of savings interest a year tax free (higher rate, £500) – including interest from bank accounts.Yet while that seems a large amount today (you'd need £33,333 at 3% before you are taxed at a basic rate), if interest rates start to rise again, the allowance won't seem so generous, and of course this will be even less so at the higher rate. See my full personal savings allowance v ISA thoughts.

• Fixed-rate cash ISAs can beat Santander

  Fixed-rate cash ISAs pay higher rates than easy-access deals. Plus unlike normal fixed savings, your money isn't locked in – you are allowed to withdraw although they can charge you interest penalties for doing so.

  For example, the Coventry Building Society pays 2.25% until November 2018. To withdraw money you can close the account (or transfer it) and you lose just 120 days of interest as a penalty. So if you did that you'd have in effect earned the equivalent of 1.51% after one year, or 1.88% after two years.

  Keep it in for the whole time and this rate does beat Santander for higher and top-rate taxpayers and is only marginally behind it for basic rate – and crucially you've got a guaranteed rate that Santander doesn't give you. For more information see our Top Fixed-Rate Cash ISAs guide.

• Santander will credit check you, a cash ISA won't

  Like all bank accounts, if you apply to Santander you will need to pass a credit check and it will leave an application footprint on your file. That isn't an issue for most savers, but you may want to avoid it just before something like a mortgage application (see our How credit scoring works guide for more info).

  Additionally, with Santander you will need to pay in an income of £500 each month to keep the account – for most people this just means ensuring your salary is paid in there – and you'll also need to have at least two direct debits coming from it.

  With a cash ISA there's no credit scoring and no income is needed to be paid into it to earn the interest and keep the account.

• So which to choose?

  For really big savers – for example those with more than £35,000 – there's no need to make a choice as you've enough to fill this year's cash ISA allowance and the Santander account. If you've less than £3,000, then forget Santander as you can earn more in other top bank savings accounts.

  The real decision comes for those with less than £35,000 and more than £3,000. Yet there is a way to get the best of both worlds. First, put your cash in the Santander account earning 3%. Then, a week before the tax year ends around the end of March, shift the cash out of the bank account to an ISA. That way you get the short-term high rate from the banks, but you still get the tax-free benefit of your ISA allowance.

• If you've big money and are likely to be able to fill your ISA allowance most years

  The more likely you are to get close to filling your £15,000 cash ISA allowance this year and next year's £15,240, the more you should hedge towards prioritising doing just that, especially if you are a higher rate taxpayer and are unlikely to need access to the cash for a while, so can get a higher rate fixed deal.

  But even if you're a basic-rate taxpayer, there is a real gain to building up a pot of savings protected from the taxman, and in years to come, when rates bounce back, the more you've got stashed under the ISA's protective cover the better – even if it means a short-term sacrifice on rate.

• If you're unlikely to fill your ISA allowance every year

  In this case, hedge more towards getting the short-term interest rate gain of Santander 123. This is because you'll still have room to shove money in a cash ISA if that becomes competitive in the future, simply because you won't have filled your allowance – and with £15,000 that's a lot of people.

  As you can see there is no hard or fast rule here – just a combination of factors that should push you one way or the other.

Is it worth removing money from an ISA to put in Santander 123?

As a final thought, it is worth noting that if you are considering removing money from an old ISA to put into a Santander 123 account, then be careful. Let's say you take £20,000 out of your old ISAs – if you wanted to put it back in at some stage in the future, with current ISA limits, it would need to be across two tax years. So if you're planning on doing that, do really weigh up whether the short-term gain is worth it.