Tax on savings interest explained: can you avoid it?

You can earn up to £1,000 interest tax free each year – but what next?

Thanks to decent interest rates and a half decent pot of cash, there’s a good chance more of us are going to max out our tax-free Personal Savings Allowance this year. And that means you could be set to pay tax on any additional interest.

So what should you do to reduce the amount you’ll pay? Here are some of things to consider.

Who pays tax on interest?

You might not realise it, but interest earned on saving is technically subject to tax at your tax rate. 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 would pay £40.

Fortunately, most of the time this doesn’t apply. 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.

However, each of these are subject to limits on how much is tax-free. When combined with increased interest rates in recent years and frozen tax bands, it could actually mean you will have to pay some tax on some of your interest.

Your tax free Personal Allowance explained

Unless you’re a super high earner, the first £12,570 of income we receive each year is tax free. For most of us that is taken up from our salaries. But if you don’t earn much or anything at all, then you can avoid tax on interest you earn under this amount.

So say you earn £10,000 a year, that leaves another £2,570 free for interest!

The Starting Rate for Savings allowance explained

There’s an extra level that’ll help wipe out tax on interest, and this is also 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 for anyone earning under £12,570 you get the full £5,000 a year allowance. That means anyone with zero income, can get the full £17,570 in interest tax free each year.

Then for every £1 you earn over £12,570 (in income other than interest), the starting rate reduces by £1. So someone earning £15,570 a year would lose £3,000 from this allowance, giving them a total of £2,000 interest they could earn before tax.

We’ve explained how the Starting Rate for Savings works in detail.

The Personal Savings Allowance explained

Even if you can’t use your Personal Allowance for savings, you still might not have to worry about paying tax on your interest.

That’s thanks to Personal Savings Allowance (PSA), worth up to £1,000 in interest that can be earned tax free. You’ll only pay tax on interest you earn over your allowance. The size of this varies depending on your tax bracket.

And for most basic rate tax payers, you need sizeable amounts saved up at the best rates to go over your PSA. We’ve explained in detail how the Personal Savings Allowance works – and a few things to watch out for.

By the way, this is on top of the Starting Rate for Savings if you’re eligible for that, giving a total of £18,570 a year tax free interest.

Cash ISAs: all interest is tax free

You’re probably already familiar with is the Cash ISA. An ISA is a type of savings account where the interest you earn is tax-free, and the Cash ISA is, as the name suggest, 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. You can read more about ISAs here.

This tax-free status 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.

However, if you’re not going to exceed about your Personal Savings Allowance then it usually makes sense to go for whichever savings account pays the higher interest rate. And even if you do earn more than your PSA outside of an ISA, that could still be worth it if the rate is high enough even after tax is deducted.

A warning here though: the government is looking to reform ISAs, and potentially reduce the annual allowance you can save as new cash. So it makes sense to use your ISA allowance this financial year if you can, even if the rate is lower, to protect your money in future years.

Premium Bonds: earn tax free prizes

Alternatively there are Premium Bonds, currently paying 3.6%. You can save up to £50,000 in these and all prizes are tax free. You can win up to £1 million pounds each month, though most people will get a lot less – if anything at all.

But there are problems with Premium Bonds is which is why for most people they should be the last tax-free allowance you go for.

First, you might not get the 3.6% rate. In fact you probably won’t. As my analysis of three different people’s wins showed, it really is all down to luck.

Plus, though you can buy Premium Bonds with just £25 (though they’re £1 each, that’s the minimum total amount), it’s incredibly unlikely you’ll win anything at all with a balance so low. In fact, even savings in the low thousands have a low chance of winning any prize, let alone one that’s close to the prize rate.