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.
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 to save to go over the personal savings allowance?
Until now, the PSA has been pretty decent for most of us. But of course it depends on how much you have saved, what rate you’re getting and the size of the allowance.
If you haven’t moved your money at all for a while it could be languishing in an account paying as little as 0.1% (or worse). As a basic rate taxpayer you’d need ONE MILLION POUNDS before you hit the PSA roof.
Of course, you’re a regular reader of the blog, so you’ve likely moved your money to a better-paying account, or maybe have fixed at a higher rate. And as rates continue to climb, it’s likely more people will be getting close to, if not passing, their PSA.
Plus, with the 40% income tax threshold frozen at £50,270 until 2026, more people than normal each year will see their PSA reduced to £500 if they get pay increases.
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 rate||Amount saved to reach £1,000||Amount saved to reach £500|
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.
So let’s say you have £20,000 fixed for two years at 3%, and the interest is due 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.
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.