Beware the savings tax trap: 2 million savers face paying tax on their interest

More than two million savers face paying tax on their interest this tax year, according to data from HMRC obtained through a Freedom of Information (FOI) request.

The taxman estimates 2.07 million savers will be hit with a tax bill, up from 1.9 million in 2023/24.

It is a big jump from three years ago, when just 647,000 people had to pay income tax on their cash savings in 2021/22.

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Laura Suter, director of personal finance at the investment platform AJ Bell, which requested the FOI, said the increase in savers being caught by tax was due to interest rates rising over the past few years plus frozen tax thresholds.

The two million savers facing a tax bill this year are split roughly into 954,000 basic-rate taxpayers, 590,000 higher-rate taxpayers and 471,000 additional-rate taxpayers, according to HMRC.

Suter notes that the number of basic-rate taxpayers being hit with savings tax has risen sharply, from just half a million in 2022/23 to almost one million today.

In total, HMRC is expecting to rake in a bumper £10.4 billion in tax on savings interest in 2024/2025.

That’s up from £9.1 billion last year (2023/2024) – and just £1.4 billion three years ago.

Suter comments: “Lots of people may have racked up a hefty tax bill already this tax year, because they didn’t realise they’d breached their personal savings allowance (PSA).

“While it might be too late to solve the problem for the current tax year, you can organise your savings and dodge some sneaky tax traps to avoid being landed with an unexpected tax bill in 2025/26.”

We look at how savings tax and the PSA work, and reveal some clever ways to avoid having your hard-saved interest siphoned off by the taxman.

How does savings tax work?

Tax on savings income is charged at your highest income tax 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 drops to £500, while additional-rate taxpayers get no allowance. 

One slightly counter-intuitive point to note about the personal savings allowance is that the interest counts when determining your tax bracket.

Consider a saver who had £49,500 in salary and £500 in savings income last year. She was just below the £50,270 higher-rate tax band and paid basic-rate tax.

Let’s say, this year, her interest rises to £1,500. This means she has £51,000 in total income, which pushes her into the higher-rate band and reduces her personal savings allowance to £500.

What size savings pots will be hit with tax?

If you have some savings squirrelled away that are not sitting in a cash ISA, you may be surprised at how quickly you breach your PSA and have to pay tax on the interest.

A higher-rate taxpayer has a £500 tax-free personal savings allowance. If you’re earning just 1% interest, you would need a balance of £50,000 to earn interest of £500 a year. But most savers are earning more than that now, given the base rate is at 4.5%. For someone earning 3% on their cash, they would need a balance of £17,000 to earn annual interest of £510 and bust their allowance.

How about a savings account paying 6%? You would only need to put £8,400 into that account to exceed your £500 allowance (as you’d earn £504 over the year). A higher-rate taxpayer who stashed £20,000 in a 6% account would enjoy annual interest of £1,200 – but would face a tax bill of £280 (£700 x 40% tax).

With interest rates remaining fairly high, savers are being urged to take into account not just the rate they get on their savings, but the potential tax implications on the interest.

You can still get about 4.75% on easy-access accounts, and 7.5% if you make the best use of regular saver accounts.

“For many years, tax on savings has been something of an aside due to low rates, but with high interest and frozen thresholds, this becomes more of a concern," comments Adam Thrower, head of savings at Shawbrook Bank.

"Savers must consider tax and the impact this might have on their overall returns as a central issue when deciding where to place their hard-earned money."

Six options to shelter from tax

1. Use an ISA

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 currently get more than 5.3% on a top easy-access ISA, and about 4.5% if you fix for one year. If you’re opening a new cash ISA – perhaps because the interest rate on your current one is rubbish – look out for ones that allow you to “transfer in” your old ISA, as this won’t count towards your annual allowance.

The current ISA allowance is £20,000 per year, meaning this is the maximum you can pay in across your ISAs (including a stocks and shares ISA) each tax year.

You could also look out for a flexible ISA, which lets you freely withdraw money and put it back within the same tax year, allowing you to take more control over your savings and cover any unforeseen expenses in life.

Suter comments: “If you have ISA allowance remaining this tax year, consider whether you should move some cash into an ISA. Equally, if you have a partner you could split the cash savings between you to use up both ISA allowances.

“If your partner pays income tax at a lower rate, it might make sense to move any savings that will attract tax into their name. Just make sure the savings interest doesn’t tip them into the next tax bracket and undo all your good organising work.”

2. Buy Premium Bonds

If you’ve maxed out your £20,000 ISA limit and still have excess savings you need to shelter from the taxman, another option is National Savings & Investments’ Premium Bonds. These don’t pay interest, but hand out tax-free monthly prizes ranging from £25 to £1 million. The prize fund rate is set to compete with prevailing interest rates.

The prize fund rate is currently 3.8% – 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, someone with average luck could expect to win around £1,900 per year. For somebody who would otherwise pay 40% tax on all that income, this means you will have avoided a £760 tax bill.

3. Overpay your mortgage

Mortgage rates have fallen slightly over the past few months: the average two-year fix is now 5.33%, while the average five-year fix is 5.18%, according to the data firm Moneyfacts.

However, these rates will still cause pain for many homeowners remortgaging after enjoying cheaper rates over the past few years.

But if you have surplus cash now – and especially any savings that are at risk of being taxed – a smart move could be to overpay your mortgage. This will increase the equity you have in your home and could get you a cheaper rate when you come to remortgage.

Overpaying also has the effect of reducing the amount of interest you pay and becoming mortgage-free faster.

Our mortgage overpayment calculator shows how your monthly repayments may change and help you decide if overpaying is worth it.

4. Pay off other bills

Do you have any bills or debts that need to be paid off? It makes sense to get rid of those rather than stashing your money away in savings – only to find the taxman takes a slice of the interest.

As well as credit cards and personal loans, you may also have bills to pay like your self-assessment tax return.

Self-employed workers usually make two payments on account each year, by 31 January and 31 July. It’s sensible to withdraw cash from a taxable savings account (in other words, not your cash ISA or Premium Bonds) to pay it.

5. Contribute to a pension

If you’re trying to reduce the amount of money you have in savings – and therefore reduce or eliminate a tax bill – another option is to pay into a pension.

This has the benefit of building up your nest egg for retirement – and most of us aren’t saving anywhere near enough – plus you get tax relief from the government.

If you have a workplace pension scheme you may find that upping your contributions also attracts a bigger contribution from your employer – this is free money, so it’s definitely worth checking.

Alternatively, you could use a low-cost self-invested personal pension (Sipp). Bear in mind that pensions can’t be accessed until age 55 (rising to 57 in 2028), so this option does involve locking your money away.

Also note the annual allowance, which is the maximum you can pay into all your pension pots in one tax year: for 2024-25 it is £60,000.

6. Consider other investments

There are other ways to save tax-free, but they involve investing your money. For example, stocks and shares ISAs, venture capital trusts (VCTs) and enterprise investment schemes (EISs) are all tax-efficient.

Before investing, think about your time horizon (in other words when you want to access the money), your attitude to risk and whether investing is right for you.

Jackie Hall, a partner at RSM, an accountancy firm, says taxpayers with significant savings and investments may need to think beyond their annual ISA allowance when considering ways to shelter their money.

She explains: “For these individuals, it may be time to think about using an alternative wrapper to house savings and investments, which may include an (offshore or onshore) investment bond or the use of a personal investment company (PIC).

“Investments held within a bond usually grow without being directly assessed to tax on the holder. The tax charges are instead deferred until the bond is encashed, although small withdrawals, of less than 5%, can usually be made each year without giving rise to any tax implications.”

According to Hall, making investments in a PIC wrapper will result in the company being assessed to corporation tax on the underlying income and gains at a rate of not more than 25%. This is 20% less than the top rate of income tax for individuals – 45% (47% for Scottish taxpayers), which means there can be significant ongoing savings.

She adds: “However, a PIC may not be suitable for short-term investment plans, as an individual will generally incur an additional layer of taxation when extracting profits from the PIC.”