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.
You’re not currently paying tax on your interest
Will you actually go over your allowance?
You might not have to worry about paying tax on your interest. Despite the higher rates available to savers, you still need sizeable amounts saved up at the best rates as a basic rate tax payer to go over your Personal Savings Allowance.
It’s set at £1,000 for those earning under £50,270, and as the table below shows, it still requires £20,000 saved at 5% for a year to earn that much. You’ll only pay tax on interest earned above £1,000. That £1,000 is still tax free.
Of course, it’s a different case if you’re a higher rate taxpayer as that allowance is halved, meaning savings of £10,000 at 5% will earn you the maximum tax-free amount of £500.
Additional rate taxpayers don’t get any PSA, so all interest is taxed.
(FYI, there’s also the starting rate of savings for those on low incomes, that could allow you to earn an additional £5,000 of interest tax free, alongside your tax allowance. More on that here.)
How much you need saved to go over the Personal Savings Allowance
|Amount saved to reach £1,000
|Amount saved to reach £500
These example balances and rate will give you an idea of when you might fill your PSA, but of course that assumes you’ve had the same amount saved at the same rate for a year. In reality it’ll be more complicated working out when you go past your allowance.
Will you get a payrise?
Though right now you might be within your PSA, could a pay rise push you into a new tax bracket, and therefore reduce the size of your tax free savings allowance?
With those Income Tax thresholds frozen until 2028, more and more of us will find our pay rises make us a higher taxpayer (it’s effectively a stealth tax hike).
So if you now earn £50,000, but get a £1,000 pay increase, you’ll find your PSA drops from £1,000 to £500, and then any additional interest is taxed at 40% rather than 20%.
If that’s possible, you might want to get ahead of the game and use more of your ISA allowance now, even if it’s at a lower interest rate.
Something to bear in mind with pay increases though is that by becoming a 40% (or 45% taxpayer) you don’t automatically see your allowance reduce. It’ll still be averaged out over the financial year. So it could be overall you’re still at a lower rate for that year (though that’ll change for the subsequent one).
Income Tax and Personal Savings Allowance thresholds 2023/24
|Personal Savings Allowance
|£1,000 (plus Personal Tax Allowance and Starting Rate)
|£12,571 – £50,270
|£50,271 – £125,140
|£125,141 and above
Could tax rules change?
In the last year we’ve seen changes to tax-free allowances for investing, with reductions to the Capital Gains Tax allowance and the Dividend Tax allowance, with further cuts to come next April.
Could the same happen to the savings allowances? Perhaps ISAs could be axed, or the amount you can save reduced. Maybe the PSA itself could be abolished (it’s only been around since 2016).
There’s nothing to say they will, but also nothing to say they won’t. So you might want to choose an ISA over other savings options to maximise your allowance and protect yourself from any theoretical rules changes.
Are you expecting a windfall?
Similarly, if you know there’s a large amount of cash coming next year – perhaps a bonus, house sale or retirement cash – you might want to put savings into ISAs now rather than wait.
You’re set to go over your Personal Savings Allowance
Will an ISA earn you more?
All the interest you earn on savings in an ISA is tax free. But if you’re not worried about going past your Personal Savings Allowance then it usually makes sense to go for whichever pays the higher interest rate. And that’s usually not an ISA (see our best buys here).
But if you will exceed it, then instinctively, you might think that you need to move some or all of your savings to an ISA (or Premium Bonds). However, it could be that even when tax is factored in, those taxable accounts still beat the rates in ISAs.
To find out you need to work out what the real rate will be after the tax is deducted, and compare the two rates. The box below takes you through how to do this.
Right now, you’ll probably find an ISA is the best bet, though that’s not always the case, so it’s worth checking.
How to compare ISA rates to non-ISA accounts
The quick way to work out which rate is better is to apply the following sum. Look for the top paying ISA rate, and multiply it by:
- 1.25 if you’re a basic rate taxpayer
- 1.66 if you’re higher rate taxpayer
- 1.82 if you’re an additional rate taxpayer
What you’ll get is the equivalent rate of interest needed before tax is removed to match that ISA.
|Actual ISA rate
|What you need at 20% tax to match it
|What you need at 40% tax to match it
|What you need at 45% tax to match it
Alternatively, you can just take your tax rate off the non-ISA account. To do this you multiply the non-ISA rate by the following:
- 0.8 if you’re a basic rate taxpayer
- 0.6 if you’re higher rate taxpayer
- 0.55 if you’re an additional rate taxpayer
This will give you the effective rate you’ll receive when tax is taken off (though do allow for rounding). Does an ISA beat it?
|Savings rate before tax
|What you’ll actually get if 20% tax is deducted
|What you’ll actually get if 40% tax is deducted
|What you’ll actually get if 45% tax is deducted
Remember though that both basic and higher rate taxpayers will still get their allowances, so this is for additional interest earned above those levels.
Can you use your ISA allowance for cash?
Assuming an ISA works out better, don’t just move all your savings across. There’s an overall £20,000 allowance on new money that can be added to ISAs each financial year, and that’s combined across all ISA types.
For most this won’t be an issue, but if you are also using a different ISA, such as a Stocks & Shares ISA for investing, you need to be aware of your over contributions the full financial year.
And if you are investing, it probably makes more sense to use your ISA allowance for that as you will be looking longer term, and therefore potentially larger gains which you’ll want to protect within an ISA.
That could mean you can’t use Cash ISAs for your savings.
Have you enough to make Premium Bonds worth it?
Alternatively there are Premium Bonds, currently paying 4.65%. But there’s a problem here too.
First, you might not get the 4.65% rate. In fact you probably won’t. As my analysis of two 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.
So ISAs should really take priority, unless you find their interest rates drop down significantly below the PB prize rate.
But if you’ve already filled your ISA allowance, and don’t have just a few hundred quid in there, these do become decent tax-free options.
Do you need this much in savings?
However, it’s also worth questioning whether savings, tax-free or not, are the best place for your money. Generally, it’s suggested you have three to six months of emergency cash in easy access accounts, and anything above this is for forthcoming expenditure you know is coming along.
With a basic rate tax payer needing £20,000 at 5% to reach their £1,000 PSA, it could be that’s more than is needed anyway. So you might be better off putting excess savings towards your pension or mortgage, or investing for a longer time frame than you’ll get in fixes (five years or more).
However, there are still some decent fixed rates available right now, even if they’re lower than what looks like a peak in late summer and early autumn. So it might be you can lock excess cash away for a guaranteed rate that could beat or be not too far off investment returns.