Beware the savings tax trap
Higher interest rates mean that many savers may exceed their savings tax allowances
The return of interest rates that are visible to the naked eye is a very welcome change for savers. You can now get 3.25%-3.5% on easy-ish access accounts, and more if you make the best use of regular saver accounts.
Still, there is one pitfall with higher rates. Over the past decade, the need to think about the tax impact of savings became less relevant for many of us. From this tax year, that won’t be the case.
Tax on savings income is charged at your marginal rate, but various allowances can shelter some of it from tax. People with little other income may be able to use some of their personal allowance of £12,570 per year to earn interest tax-free.
They may also benefit from the starting rate for savings, an allowance that begins at £5,000 and is reduced by £1 for every £1 of other income above your personal allowance.
Once your other income gets above £17,570, you no longer get the starting rate for savings, but basic rate taxpayers have a personal savings allowance of £1,000 of interest tax-free each year.
For higher-rate taxpayers, that falls to £500, while additional-rate taxpayers get no allowance. One slightly counter-intuitive point to note about the personal savings allowance is that the money still counts when determining your tax bracket.
Consider a saver who had £49,500 in salary and £500 in savings income last year. He was just below the £50,270 higher-rate tax band and paid basic-rate tax.
This year, interest rises to £1,500, meaning £51,000 in total income. That pushes him into the higher-rate band and reduces his personal savings allowance to £500.
Two options to shelter from tax
When rates were 1%, even £50,000 in savings wasn’t generating much taxable income. But at 3%, that could mean an extra £400 per year in tax for a higher-rate taxpayer, making it important to shelter what you can.
Assuming that you still want to hold cash, rather than put it into investments or a pension, the first option is a cash individual savings account (Isa).
Interest is tax-free and you can now get 3%-3.25% with fairly easy access. A flexible Isa, which lets you freely withdraw money and put it back within the same tax year, could be an alternative to standard easy-access accounts – at the cost of reducing what you can put in an investment Isa.
The other choice is National Savings & Investments Premium Bonds. These don’t pay interest, but hand out tax-free monthly prizes ranging from £25 to £1m. The prize fund rate on these is set to compete with prevailing interest rates.
This is currently 3.3% – but it’s skewed by the larger prizes that you are very unlikely to win. The average saver with average luck will get a much lower rate of return. Those with only a small amount are likely to end up with nothing.
However, with the maximum holding of £50,000, you would expect to win around £1,300 per year. That’s a (non-guaranteed) taxfree return of 2.6%. For somebody who would otherwise pay 40% tax on all that income, this is equivalent to a pre-tax return of 4.3%.