Will you pay tax on your savings?

As interest rates improve, you could face a tax on the interest you earn.

Most of us will have avoided paying tax on our savings for years. Really low rates have meant we’ve not even had to bother with the tax-free ISA account to protect our interest.

But as savings rates improve, and look set to continue climbing, it could mean you need to reassess where you put your cash.

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When you pay tax on savings

For most people, you’ll only pay tax on savings if the interest you earn is above the Personal Savings Allowance (PSA) threshold. For basic rate taxpayers that’s £1,000 you can earn tax-free, while for higher rate taxpayers it’s £500. Additional rate taxpayers don’t get the allowance.

If your money is held in a Cash ISA then you don’t need to worry about the PSA, but there is a maximum £20,000 that can be added to your savings each financial year. And since Cash ISAs tend to pay lower interest rates, they’ve rarely been worth it since the PSA was introduced.

Elswhere, there’s no tax due on winnings via Premium Bonds, while low earners can benefit from an increased tax-free allowance via the Start to Save Scheme. I’ve written more about all four of these options if you want more detail.

How much do you need saved to pay tax?

As explained, you won’t pay tax on interest from ISAs or wins from Premium Bonds. So it’s only money held outside this that could be taxed, and only if it goes over your PSA. I’m assuming in these examples that you’re not eligible for the starting rate of savings to boost your tax-free allowance.

The standard £1,000 allowance is decent for most, though when you look at interest rates right now compared to a year ago, more people will be using it all up.

Two years ago, the best you could get was 0.6% and you’d need to have a massive £166,666 held in that account to earn £1,000 in interest. A year ago it was around 3%, when a still sizeable £33,000 would be required.

But rates have improved (see the latest best buys here). Now the best easy access account pays around 5.2%, while the top one year fix is currently 5.5%%, having peaked at around 6.2% last autumn.

These require savings of £16,000 to £20,000 to go over the allowances for a basic rate tax payer. And the balance thresholds drop to £8,000 to £10,000, give or take, for those with the reduced PSA of £500.

Here are some example interest rates and the balances required at those rates to go over your PSA.

Interest rate	Amount saved to reach £1,000	Amount saved to reach £500
0.1%	£1,000,000	£500,000
0.5%	£200,000	£100,000
1%	£100,000	£50,000
2%	£50,000	£25,000
3%	£33,333	£16,667
4%	£25,000	£12,500
5%	£20,000	£10,000
5.2%	£19,230	£9,615
6%	£16,667	£8,333
6.2%	£16,130	£8,065

Warning: Fixed rate interest and the PSA

The above examples all relate to when you receive the tax. With most easy-access accounts that’ll be monthly. But with some regular savers and fixed-rate savers, it could be you get paid all the interest when the term is up. In fact, even if it’s paid monthly, if you can’t access it until the term is up, it’ll all count from that final date.

So let’s say you have £20,000 fixed for two years at 3%, and the interest is accessible at the end of the year rather than monthly. The total interest you’ll earn is £1,218, which will fill your entire PSA when it arrives, and you’d pay 20% tax on the £218 over the allowance (and any interest earned on other savings that year).

Not all accounts work like this, but check any accounts you have or plan to open so you can make sure any additional saving don’t also get taxed. This lump sum calculator will help you work out what you might make.

What to do if you’ll go over the PSA

It’s worth thinking ahead to see if you’ll earn more than your allowance rather than wait until the end of the financial year when it could be too late.

Save less

Don’t forget you only really need three to six months of essential expenses easily available in cash. 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.

If you’re happy with this then any additional money can go towards investments, pensions or overpaying your mortgage.

Pay the tax

When you compare the latest best buy ISA rates with the best buy easy-access accounts, you’ll see a significant difference (1.55% vs 1.9%). However, if you’re going over your PSA, the latter rate will be subject to tax (but only on the interest earned above the allowance, not the whole amount).

Assuming you pay 20% tax, adding that to a 1.9% account, would give a real rate of 1.52%. In this instance that’s not much difference, so you might decide to just keep the cash saved and pay the tax.

As rates continue to change it could be that the difference increases or decreases, so it’s worth checking this before you start moving your money.

Use your ISA allowance

Though the example above was borderline, it’s very different if you pay 40% tax. In that case the real rate would become 1.14%. You’d be much better off putting those extra savings into your ISA – as long as you have the annual ISA allowance.

The other advantage of using your ISA allowance is that it protects your interest from tax if you get a payrise that cuts your PSA allowance in half – of if the Government decides to change or scrap how it works.

Remember if you’ve previously moved money into an investment ISA or Lifetime ISA, that will count towards your £20,000 total.

Use Premium Bonds

The current prize rate for Premium Bonds can easily be beaten by the best savings rates, but I think there’s still a place for short-term large sums.

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.