Tax on savings explained

Find out how Cash ISAs, the Personal Savings Allowance, Premium Bonds and the starting rate can stop you paying tax on savings.

In my live YouTube Q&As I’m often asked about how much tax is due on savings, or which is the best Cash ISA, and my answers are often “none” and “there isn’t one” respectively.

That’s largely because of something called a Personal Savings Allowance (PSA) which eliminates or reduces the tax most will pay on your savings regardless of the account the money is held in.

But that’s not the only allowance or account that will mean you can earn interest tax-free. Here’s how the PSA and other tax-free savings options work in the UK.

Tax and your savings

You might not realise it, but interest earned on saving is technically subject to tax at your tax rate. As long as you’re earning more than £12,570 a year you will be paying tax.

So if you’re a basic rate taxpayer and earn £100 in interest in a financial year, you’d pay £20 of that in tax. Higher rate taxpayers (earning above £50,270 a year) would pay £40.

But there are four ways to avoid this payment to HMRC: Cash ISAs, the Personal Savings Allowance, the starting rate for savings and finally Premium Bonds.

The Cash ISA tax-free allowance

The one most are familiar with is the Cash ISA. An ISA is a type of savings account where the interest is tax-free, and the Cash ISA is (as the name suggests) one for cash savings rather than investments.

There’s an annual ISA allowance, which limits how much you can pay in one each year to £20,000, though that allowance resets for new deposits each April. That means once the money is in an ISA, it will keep earning tax-free interest year after year.

This is why so many people have the idea in their heads that they need an ISA for their savings. And for a while it was often the best place to stash your cash. But since 2016 (so quite a while now) there’s also been the Personal Savings Allowance (PSA).

The Personal Savings Allowance

Most of you reading this will be entitled to a PSA. This allowance isn’t about how much money you can save tax-free, instead it’s based on how much interest you can earn before tax is due. And it’s a decent amount.

How much is the Personal Savings Allowance?

If you’re a basic rate taxpayer you have an allowance of £1,000 in interest earned before tax is due. If you’re a higher rate taxpayer, the Personal Savings Allowance is £500. Additional rate taxpayers lose the PSA completely.

The standard £1,000 allowance is huge, especially when you look at current interest rates. Hopefully you’re all regular readers and have your easy access savings in an account paying at least 0.6%, which has been the best rate, give or take, for the last few months. You’d need to have a massive £166,666 held in that account before you start paying tax on the interest.

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If you haven’t moved your money at all for a while it could even be languishing in an account paying as little as 0.1% (or worse). And you’d need ONE MILLION POUNDS before you hit the PSA roof.

Of course, you might have moved your money about in a few different accounts, some of which might pay as much as… 2% (don’t get too excited now). Or you might be a higher rate taxpayer so have a PSA of £500. Then the amount saved will be lower, but even so, you’d still need to have very healthy amounts saved up before tax becomes an issue.

Here’s how much you’d need to have saved at a few different rates to earn either £1,000 or £500 in interest.

Interest rateAmount saved to reach £1,000Amount saved to reach £500
0.1%£1,000,000£500,000
0.6%£166,666£83,333
1%£100,000£50,000
2%£50,000£25,000
3%£33,333£16,666
4%£25,000£12,500
5%£20,000£10,000

As you can see from the table, higher interest rates of 3% and above would quickly reduce the amount you can save and earn tax-free interest, but we’re some distance from these levels being accessible for large sums of cash.

Don’t forget you only really need three to six months of expenses available in cash, with the rest invested for the longer term. Even if you wanted a year’s worth available I’d doubt many people will need to have above £30,000 saved up. Probably a lot less.

Of course there will be short-term exceptions, such as savings for a house deposit that could take you above those levels – though right now the rates available mean that’s not going to be a concern.

So for most of us, all we need to worry about when looking for a savings account is the best interest rate, not whether we’ll be able to earn tax-free interest.

The starting rate for savings tax allowance

There’s a third level that’ll wipe out tax on interest, and this is for low earners. There’s effectively an extra £5,000 allowance for interest earned, though how much you’ll get depends on your salary.

To be eligible you need to earn less than £17,570 and the total amount is a little complicated. For anyone earning under £12,570 you get the full £5,000 a year allowance.

Then for every £1 you earn over £12,570, the starting rate reduces by £1. So someone earning £15,570 a year would lose £3,000 from the allowance, giving them a total of £2,000 they could earn.

This is in addition to the PSA which would be worth the full £1,000.

Premium Bonds

The final account that’ll pay you tax-free returns is the Premium Bond. Though you’re not guaranteed interest, any prizes you do win are paid tax-free. If you have an average rate of luck and more than £5,000 saved, these should equal or beat the interest rate on the best easy-access accounts.

There’s a limit of £50,000 that can be held by an individual in a PB. Here’s more about how Premium Bonds work and how they compare to savings accounts.

What about joint accounts?

Technically any interest earned in joint accounts is split down the middle. So say the account receives £100 in a year, you’ll both put £50 towards your respective allowances.

What’s the best savings account?

Andy’s analysis

Very simply, go for the savings account (or accounts) that offer the highest interest rates. That could well be an ISA, though it’s more likely to be a specialist current account or app.

At the time of writing this, the rate should be a minimum of 0.6%, though it’s possible to get 2% in a handful of places. I also think it’s worth considering Premium Bonds if you have large sums of cash.

Just remember that you don’t need to have too much held in cash. Look to three to six months of emergency spending at most. Beyond that it will make sense for most people to put the money in a Stocks and Shares ISA, your mortgage or your pension to get the best return.

When an ISA can be useful

Obviously if the interest you’ll earn is going to take you above the PSA then putting some of the cash in a Cash ISA can make sense (though the same can be said for Premium Bonds).

ISAs are also something to bear in mind if you see interest rates rising, which could see you reach the PSA level sooner than you currently are.

And there’s also no guarantee that this or a future government won’t slash the PSA levels, or even remove it completely. In which case you might want to ring-fence some cash in ISAs to future proof its tax-free status.

If you do this, don’t forget that the £20,000 allowance is split between all the different ISA types such the Stocks and Shares ISA or Lifetime ISA.

3 thoughts on “Tax on savings explained

  1. What about the non-Cash ISA types?
    “The Cash ISA tax-free allowance”
    Are you suggesting that it is only the Cash ISA that is has a tax-free allowance, the other ISA types would not have a tax-free allowance?

  2. Hi Andy,
    I am a long time saver and am always looking for trends of where to invest.

    I have noticed that in general, the stock market does very well when the economy is not doing so.

    Currently, Covid and Brexit and the supply chain have put pressure on many companies and many will still go to the wall in the near future.
    So, although we are told that the economy is doing well I do not think this is so.
    If I’m correct, should I be investing in the stock market at this time?
    Further, if the government is borrowing millions would it be better to invest in bonds?

  3. One trick in case interest rates do go up and you want to retain an ISA, but non ISA accounts are paying more currently, is this. Take the money from your ISA apart from a token amount. Your ISA will need to be the flexible type. Pay it into a non ISA that gives better rates. Just before the end of the end of the tax year, draw the money from the taxable account and pay it back into the ISA. You can put all the money you took out plus any remaining ISA allowance for the current year. Once the tax year has ended, draw the money from the ISA again and pay it back into the taxable account. This way you should earn more interest, but retain the potential amount you could have in a ISA. Repeat the process each year and if interest rates do rise significantly, you have the advantage.

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