I fear Judi may become even more confused once she's read this! !;D

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All that matters is the AER. Two accounts with the same AER (one paying interest monthly, one annually) will both pay out the same net interest and will both pay the inland revenue the same tax provided the interest is retained in the account.

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Sorry this is wrong. It is only the

__gross__ rates that compound to be equivilent. This is comfirmed by the definition from the British Banking Association: "The Annual Equivalent Rate is a notional rate quoted in advertisements for interest-bearing accounts which illustrates the contractual (gross) interest rate (excluding any bonus interest payable) as if paid and compounded on an annual basis." (from

http://www.bba.org.uk/bba/jsp/polopo...135&a=1575 )

It is mathematically impossible for both the gross and net AERs for the monthly and annual accounts to be the same as each other (unless either the tax rate or the interest rate is 0%). If the gross AERs are the same, the net AERs have to be different. The net rate will always compound to slightly lower figure. I have a first class degree in mathematics, and would be very interested to see your calculations if you believe that the net AERs can possibly be identical at the same time as the gross AERs being identical.

The other thing you need to understand is the circumstances in which the rates will be equivilent. Because of the way an AER is defined, they are

__only__ equivilent if the the money is left intact for 12 months, and the balance never increases or decreases (apart from the interest credits). I shall demonstrate this with a simple ( !

) example (I've ignored tax). Suppose A opens an annual interest paying 5% annually on 1 Jan 04. B opens a monthly account paying an an AER of 5%, which makes the monthly rate 4.89% (figures derived from ING). If both deposit on 1 Jan and leave the money to compound gross for 12 months, then the final balances will be the same. But suppose both put £0.01 in there for 11 months, and then at the start of month 12 deposit £99,999.99 (extreme example I know, but it illustrates the point!).

In month 12, A earns £100,000x5%x1/12=£416.66.

In month 12, B earns £100,000x4.89%x1/12=£407.50.

Interest is added to both accounts on 31 December (being the end of the year for A, and the end of the month for B). On that date A, has a balance of £100,416.66, but B only has £100,407.50. Essentially B has lost out on his compounding. If the money is in place for a year, B is compensated for his lower rate by the monthly compounding. But in the example above, he has received no compunding because he received no interest on which to compound during the first 11 months. So the rate, which were apparently equivilent, are in fact not equivilent.

It is a common misconception that annual equivilent rates are always equivilent - they are not (as the example demonstates). The monthly and annual interest will generally only be identical if:

1) The interest rolls up gross, and

2) No deposits or withdrawals are made from the account, and

3) Interest on the annual account is paid 12 month after the opening date (if it is paid sooner, then again annual will beat monthly).

Otherwise the figures will be different, although I stress again the differences will usually be relatively small and unlikely to be worth worrying about. By the way, I'm not necessarily saying than monthly interest will always be worse than annual interest. There are circumstances in which monthly interest will work out better (generally where the balance is reducing over the year).

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When you get interest monthly, it is not correct to say that 20% tax has been taken from each gross monthly payment. Just enough tax is deducted so that the amount compounds and adds up to 20% tax for the year as a whole.

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Really? Perhaps you should tell the Inland Revenue so that the bank in question can be prosecuted! When a bank or building society pays interest it is obliged to deduct lower rate tax under ICTA1988 (unless it is an ISA or the saver has registered for gross interest). If they deduct either more or less than 20% (subject to rounding to the nearest penny) they are breaking the law. Can you give me a single example of a bank which has deducted less than 20% on a monthly interest payment? !Do you have any links to any websites which confirm that banks use this procedure?

In any evernt, it would be mathematically impossible to adjust the tax deducted from monthly interest as you describe. The only way this could be achieved is by deducting no tax at all from the monthly interest and paying it all at the end. Unless the full gross payment is credited to the account each and every month without any deduction of tax at all, then it is a mathematical certainty that the net balance after 12 months will be lower than with annual interest (although as I said before these differences are very small). In fact you would pay slightly less tax with monthly interest (because you would earn slightly less interest).

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This is why with savings accounts which pay interest monthly the tax is not included on monthly statements, but is only shown on your annual statement (usually sent out after the end of the tax year).

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All the monthly interest accounts I have, apart from Ing, show the tax deduction every month, and it is always 20%. Even with Ing you can even track the gross interest, as the statement tells you the gross interest earnt in the calendar year to date. If you deduct the net interest credited to the account in the same period, that gives you the tax deducted to date. This will be 20% of the gross interest.