Millions of savers face a tax bill on their nest egg for the first time in seven years. Soaring rates and increased savings balances put them at risk of busting their Personal Savings Allowance (PSA).
Introduced in 2016, this allowance makes the first £1,000 of annual savings interest tax-free for basic-rate taxpayers. Higher-rate taxpayers get £500. Additional-rate payers receive nothing.
It comes on top of any tax-free interest you earn on your cash Isa.
– Check out This is Money’s best Isa rates here.
The Personal Savings Allowance gives basic-rate taxpayers their first £1,000 of annual savings interest tax-free. Higher-rate taxpayers get £500
As unsuspecting savers now risk being stung by big tax bills, Money Mail explains what you need to know to avoid getting caught out…
Brace for possible allowance blow
When savings rates were in the doldrums, the PSA seemed generous. Early last year, the best easy-access account paid just 0.5 per cent.
A basic-rate taxpayer would have needed £200,000 in an account to reach the £1,000 interest level allowed before the tax was due. This meant that most people didn’t need to think about tax on their savings at all.
Even for 40 per cent higher-rate payers, the sum you could save before breaching the allowance was £100,000.
But now easy-access rates pay as much as 3.25 per cent, following last month’s rise in the Bank of England base rate from 3 per cent to 3.5 per cent.
In an account paying 3.25 per cent you’ll reach your personal savings allowance with £30,770 as a basic-rate payer and £15,385 as a higher-rate one.
Rates on best-buy one-year bonds have risen to a decade high of 4.6 per cent, while five-year bonds are above 5 per cent.
At 5 per cent interest rates, you’ll use up the annual allowance with a £20,000 pot as a basic-rate payer, or £10,000 as a higher-rate one.
Calculate tax on your savings
Three allowances offer potential tax breaks on your savings interest: the Personal Allowance (£12,570 for this tax year), the £5,000 so-called ‘starting savings rate’ and the PSA.
To work out whether you owe tax, you first need to separate your savings interest from your non-savings income. Then look at your allowances in a set order — first using your Personal Allowance.
Say you earn £16,000 from a job or pension and £4,000 in savings income. Set the Personal Allowance against your income.
You pay nothing on the first £12,570 and 20 per cent on the remaining non-savings income of £3,430 (£16,000 minus £12,570). This adds up to a tax bill of £686 on your income.
Next, you need to factor in the £5,000 ‘starting rate’ for savings interest. This is aimed at those on low incomes (if your other income is £17,570 or more, you won’t qualify for any of it).
For every £1 of non-savings income over your personal allowance, the rate is reduced by £1.
Top deals: Rates on best-buy one-year bonds have risen to a decade high of 4.6%, while five-year bonds are above 5%
So, in the example above, you deduct the £3,430 you earned above the personal allowance from your £5,000 ‘starting rate’ limit to give a starting rate allowance of £1,570.
This means you can earn £1,570 from savings before any tax is due.
So deduct your £1,570 tax-free sum from the total £4,000 interest you earned on your savings. That leaves £2,430 (£4,000 minus £1,570) of potentially taxable savings income.
Finally, you can apply the Personal Savings Allowance. If you are a basic-rate 20 per cent taxpayer, you can earn another £1,000 tax-free using this allowance.
That leaves £1,430 that is liable for tax. Basic-rate taxpayers will pay 20 per cent tax on this — or £286.
So your total tax bill for the year is £972 (£686 on a pension or salary, plus £286 on savings income).
The sums are slightly different in Scotland, where tax rates are 19 per cent, 20 per cent, 21 per cent and 41 per cent.
Beware the fixed-bond trap
You could run into a complication with interest on fixed-rate bonds. On a three-year bond, for example, you can’t always use your Personal Savings Allowance against the interest for each of the three years.
Instead, you only have one year’s allowance in the tax year that the bond matures.
The crucial point as far as HM Revenue & Customs (HMRC) is concerned is whether you can get your hands on your money during the term of the bond.
If you can, then you normally pay tax on your interest each year — even if you don’t touch it. Here, you qualify for the PSA for each of those years.
But if you don’t have access to your capital or interest during the term, you are not liable for tax on any of the interest until the bond term ends.
You can only apply that year’s PSA to the whole three years’ interest.
You can’t trick the taxman
If you bust your Personal Allowance, HMRC will know.
Banks, building societies and National Savings & Investments report how much interest they have paid you in the tax year to April.
This information filters through to HMRC during the summer months. It then adjusts your tax code in order to take any tax that you may owe. The amount you have earned above your allowance will show up here.
You don’t need to tell HMRC how much interest you have earned unless you fill in a self-assessment form.
But you can tell the taxman your estimates if you think the code is likely to be wrong. For example, you may have had a lot more in savings two years ago than you do now.
Always check your code — it is based on the information that HMRC holds on you, which could be incorrect.
You can correct details online (gov.uk/personal-tax-account) or call 0300 200 3300.
Alternatively, you can also write to Pay As You Earn And Self Assessment, HM Revenue & Customs, BX9 1AS.