Millions of savers face a tax bill on their nest egg for the first time in seven years. Rising rates and increased savings balances have put them at risk of exhausting 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. Extra-rate payers get nothing.
This comes on top of any tax-free interest earned on your Cash ISA.
– Check that this money has the best ISA rates.
The Personal Savings Allowance gives the first £1,000 of annual savings interest tax-free to basic-rate taxpayers. Higher rate taxpayers get £500
As the unsuspecting saver now risks getting stung by big tax bills, Money Mail explains what you need to know to avoid getting caught…
Brace for possible allowance blowout
When savings rates were in limbo, the PSA appeared to be generous. Early last year, the Best Easy-Access Account paid just 0.5 per cent.
A basic-rate taxpayer would need £200,000 in the account to reach the allowed £1,000 interest level before tax is due. This meant that most people did not need to think about taxes on their savings at all.
Even for those paying the 40 per cent higher rate, the amount you could save before breaching the allowance was £100,000.
But now the easy access rate pays 3.25 per cent after the Bank of England increased the base rate from 3 per cent to 3.5 per cent.
In an account paying 3.25 per cent you would reach your Personal Savings Allowance with £30,770 as a basic rate payer and £15,385 as a higher rate payer.
Rates on Best-Buy one-year bonds have risen to a decade high of 4.6 percent, while five-year bonds are above 5 percent.
At 5 per cent interest rates, you would use the annual allowance with a £20,000 pot as a basic rate payer or £10,000 as a higher rate payer.
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 ‘introductory savings rate’ and the PSA.
To find out whether you owe tax or not, you must first separate your savings interest from your non-savings income. Then view your allowances in a set order – using your personal allowance first.
Let’s say you earn £16,000 from a job or pension and have £4,000 in savings income. Set a personal allowance against your income.
You pay nothing on the first £12,570 and pay 20 per cent (£16,000 minus £12,570) on the remaining non-savings income of £3,430. This adds to your tax bill of £686 on your income.
After this, you need to take into account the ‘introductory rate’ of £5,000 for savings interest. It is aimed at people on low incomes (if your other income is £17,570 or more, you won’t qualify for any of this).
For every £1 of non-savings income on your Personal Allowance, the rate is reduced by £1.
Top Deals: Rates on Best-Buy one-year bonds have risen to a decade-high 4.6%, while five-year bonds are above 5%
So, in the example above, you subtract the £3,430 earned on top of the Personal Allowance from your £5,000 ‘starting rate’ threshold to give a starting rate allowance of £1,570.
This means you could earn £1,570 from savings before any tax is due.
So subtract your £1,570 tax-free amount from the total £4,000 interest earned on your savings. That leaves £2,430 (£4,000 minus £1,570) of potential taxable savings income.
Finally, you can apply the Personal Savings Allowance. If you’re a 20 per cent basic-rate taxpayer, you can use this allowance to earn an extra £1,000 tax-free.
That leaves £1,430 which is liable to tax. Basic-rate taxpayers would pay 20 per cent tax – or £286 – on this.
So your total tax bill for the year is £972 (£686 on pension or salary, £286 on savings income).
The amounts are slightly different in Scotland, where the tax rates are 19 per cent, 20 per cent, 21 per cent and 41 per cent.
Beware the Fixed-Bond Trap
You may 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 interest for each of the three years.
Instead, you only have one year of allowance in the tax year the bond matures.
As far as HM Revenue and Customs (HMRC) are concerned, the key point is whether you can get your money during the term of the bond.
If you can, you typically 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 the capital or interest during the term, you are not liable to tax on any interest until the bond expires.
You can apply the PSA of that year only to the interest for the entire three years.
you can’t trick the tax officer
If you lose your personal allowance, HMRC will know.
Banks, building societies and National Savings and Investments report how much interest they paid to you in the tax year up to April.
This information is filtered by HMRC during the summer months. It then adjusts your tax code to match any taxes you’re owed. The amount you’ve earned on top of your allowance will appear here.
You don’t need to tell HMRC how much interest you’ve earned unless you fill in a self-assessment form.
But if you think the code is likely to be wrong, you can report your guess to the tax authority. For example, you may have had much more savings two years ago than you do now.
Always check your code – it’s based on the information HMRC holds on you, which could be wrong.
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.
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