This account pays 6.3% on your savings - tax-free!

Find out how some savers are earning 6.3% on their savings, tax-free - without using up any of their ISA allowance.

The news this week that RPI inflation has jumped to 5.3% no doubt made many savers want to weep.

It means that, if you want to stop your money from deteriorating in value, you now need to find an account that pays 6.6% if you’re a basic rate taxpayer and 8.8% if you’re a higher rate taxpayer.

Unfortunately, the best online easy access savings account – the Alliance & Leicester
Online Saver Issue 7 account – pays just 3%.

Believe it or not, you’re actually better off sticking your savings in a current account. You can earn as much as 5%, and still have instant access to your money.

Take a look at this table:

These accounts are by far the best option for savers who need instant access to their cash. Just be aware that with the Santander and Lloyds TSB accounts you must deposit at least £1,000 a month while Alliance & Leicester requires at least £500. Of course, you can instantly withdraw this money - or, if you’re really clever, send it to back and forth between all three accounts via standing orders.

The rates on all three accounts are fixed, but with the Santander and Alliance & Leicester accounts, the interest rate includes a temporary 4% “bonus rate” for the first 12 months, so make sure you find a new home for your money after a year.

Now, you might think that sounds like a super deal. But if you don’t need instant access to your cash, there’s an even better account out there - and it has long been my favourite savings account:

The NS&I Index-Linked Savings Certificate

OK, so it doesn’t sound very sexy. But it is. In fact, it’s so sexy, Right Said Fred should write a song about it.*

This account pays - wait for it - 1% above the RPI (a measure of inflation), TAX-FREE.

This is a fantastic return when you consider that RPI is currently 5.3%. And this is not an ISA and so putting savings in this account won’t affect your ISA allowance. In other words, you can save tax-free in this account in addition to saving tax-free in your ISA.

How can NS&I get away with offering a special tax-free account like this? Because NS&I is owned by HM Treasury - which means 100% of your savings are guaranteed by the British Government.

NS&I is the safest place in the UK to put your money and there’s no need to worry about the £50,000 compensation cap. You can save as much money as you like with NS&I and your money will be as safe as the crown jewels. Literally.

A word of warning

These certificates are designed to enable you to beat inflation by 1% over the period your money is invested. So the people who are benefiting from the 5.3% inflation rate at the moment are the people who invested a year ago.

If inflation falls over or stays level during the next year, you are still guaranteed to beat inflation by 1%, but you will not earn 6.3% unfortunately.

It's a complicated calculation which I've explained in more detail below, but the key thing to bear in mind is that you are guaranteed a tax-free, inflation-busting return. If you are happy with that guarantee (or worried that inflation will rise), then go ahead and get it. But it is impossible to say whether this certificate will continue to pay out the highest rate available to taxpayers.

Which certificate should you go for?

There are two different types of index-linked savings certificates you can get, a three-year bond and a five-year bond. The good news is, you can decide to lock your money away in either of these bonds and then change your mind at any time and access your money. However, you will face an interest penalty, so if you think this is likely to happen, go for the three-year bond as the penalty is smaller.

Here’s how it works out:

As you can see, in contrast to most fixed rate bonds, the interest penalty you pay for early access is relatively small. If you opt for the three year bond and then change your mind and decide to take your money out after just one year, you will still earn 0.85% plus the RPI over that year.

Just another reason why I really like this product!

The catches

There are always a few, aren’t there?

First point is that you have to invest at least £100 and you cannot invest more than £15,000 in each issue of each type of certificate right now. However, each time a new issue of the certificate goes on sale, you can invest another £15,000.

In the event of a decrease in the RPI over the period of time your money has been invested, NS&I promise that the maturity value of your bond will never be less than the preceding anniversary value or, if your money is invested for less than a year, the purchase price. So instead of getting RPI +1%, RPI will be deemed zero, but you will still get +1% interest on your savings.

Related how-to guide

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Ultimately, this bond is best suited to savers who would like the peace of mind that comes with a safe, guaranteed real return on a long-term investment. Personally, I have been a fan of these savings certificates for years and have even recommended it to my own father, who as a pensioner needs all the help he can get to beat inflation.

So that's what I think. But how about you? Have you ever taken out one of these bonds? Share your experiences using the comments box below!

Compare savings accounts at lovemoney.com

Show me some calculations

I know some of you find working out the rate on these certificates a bit confusing so I have asked NS&I for a worked-out example. This is where it gets a bit technical, so if you're not interested in the maths, just take it from me that you get 1% above inflation tax-free, and skip the next bit!

OK, let's imagine you invested £10,000 in a three-year issue of Index-linked Savings Certificates in May 2009. This would, on its first purchase anniversary in May 2010, earn £444.87 index-linking. This is calculated as: Purchase price x RPI end level (which in March 2010 was 220.70), divided by RPI start level (which in March 2009 was 211.30). Or 10,000 x (220.70 ÷ 211.30) = £10,444.87.

You would also earn the guaranteed fixed rate of interest of £85 or 0.85%. The first anniversary value of £10,529.87 would then be used as the basis on which the second anniversary value is calculated in May 2011. Therefore if you invested last May, you would have needed a return of 6.62% as a basic-rate taxpayer, 8.83% as a higher-rate taxpayer, or 10.60% as an additional rate taxpayer to obtain an equivalent return on your savings.

Still confused about how these certificates work? If you are at all concerned that these calculations might be wrong, or if you feel that you need a bit more clarity about whether these certificates do actually pay the rate stated in this article, you will be pleased to hear NS&I has addressed your concerns and written this article for us: How NS&I index-inked savings bonds really work. Please read it and let us know your thoughts! Read the article

*I'm too sexy for this savings certificate, too sexy for this certificate, so sexy I want to pontificate (about this sexy certificate)...

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