Author: Anna Bowes | Co-Founder – Savings Champion
Whilst borrowers are feeling the negative effects of rising interest rates, it’s been a good time for savers. Since December 2021, the Bank of England base rate has been increased 14 times, from a historic low of 0.10% to a 15 year high of 5.25%. And although over the preceding years there seemed to have been a disconnect between the base rate and cash savings rates, the good news is that as the base rate has risen, so too have many savings rates – giving savers desperately needed extra pounds in their pockets.
But there are a couple of things to watch out for with this good news.
Firstly, not all rate rises are equal. Some banks and building societies have passed on far more of the interest rate hikes to their customers than others. You can’t simply assume that you have been treated fairly, unless you have a base rate tracker account and even then, only if it is a tracker that actually tracks the base rate, as some simply guarantee to pay no less than a certain amount below! It makes sense to check the rate of interest you are now earning and move it if you feel you are not earning a competitive amount.
The other big issue facing savers is that many more will now be paying income tax on their interest, something that was not an issue following the introduction of the Personal Savings Allowance (PSA) in April 2016. The PSA means that basic rate taxpayers pay no tax on the first £1,000 of interest earned each year, while for higher rate taxpayers they have a £500 allowance. Additional rate taxpayers don’t receive a PSA.
At the time the PSA was introduced, HMRC declared that around 85% of savers would no longer pay tax on their savings, and as interest rates dropped to record lows, even more people would have fallen into this camp.
But as interest rates have increased, the amount you need to have in savings before the PSA is breached has fallen sharply, especially since the allowance has remained frozen since inception.
For example, when the top easy access account was paying 0.50%, a basic rate taxpayer would have needed a deposit of £200,000 to breach their PSA, however, with easy access accounts now paying 5% or more, just £20,000 will generate £1,000 in gross interest.
HMRC has estimated that the Government will earn £6.6bn in tax from savers in the current tax year, up from £3.4bn in 2022/23 – that’s an increase of 94%! So while savers are earning more then they have for years, the taxman is definitely one of the biggest winners all the same.
What do I need to do if I breach the Personal Savings Allowance?
When the PSA was introduced, the biggest change to our savings was the way that interest was paid. Before the PSA, interest was paid after the deduction of basic rate tax, unless you were a non-taxpayer and completed an HMRC form to confirm this. However, from April 2016 this changed and all interest is now paid tax free, because at that time, the majority of savers would no longer need to pay tax on their savings interest.
For those who are part of the PAYE scheme – so anyone with employed income or pension income – HMRC will take an estimate of tax due based on your tax code. BUT, this will be based on old information supplied by the banks and building societies – the actual interest you earn over the coming year may be very different, especially if you have added or removed large amounts of cash since the last tax year.
So it’s important to review your tax code letter which shows the interest HMRC has assumed you will earn and inform HMRC if things don’t look right.
Some savers will be eligible for the starting rate for savings, which means that you can earn an extra £5,000 in interest before it is liable for tax, however this only applies to those whose other income (so wages or pension income for example) does not exceed £17,570.
If you already do a self-assessment tax return, you can pay any tax due via that process.
What can savers do to reduce the tax they have to pay?
The good news is that there is a pretty simple solution to protecting more of your savings interest from the taxman – and that is by using cash ISAs.
Following the introduction of the PSA, the importance of the cash ISA waned and according to figures from the Bank of England, the amount held in cash ISAs fell steadily.
But all that is changing. Cash ISAs have become very important again, as any interest earned within this tax-free wrapper does not count towards your PSA – it remains out of the taxman’s clutches. And the good news is that the gap between cash ISAs and the equivalent non-ISA savings accounts has narrowed considerably recently. As a result, ISAs are a good idea for those who can no longer avoid paying tax on their savings.
A couple of years ago, the decision wasn’t quite as simple as the gap between the top ISA rates and the equivalent bond rates was much wider. Back in October 2021, the top paying 1-year bond was paying 1.35% (1.08% after the deduction of basic rate tax), whilst the top ISA was 0.90%. That meant that a basic rate taxpayer would have still earned more in the bond rather than the ISA, even if 20% tax was deducted from the bond.
Today though that gap has narrowed considerably – so the top bond at the time of writing is paying 6.11% (which is 4.89% net after the deduction of basic rate tax) whilst the top ISA is paying 5.75% tax free. A much better rate than the net amount that could be earned on the bond after the deduction of tax. So cash ISAs are nicer once again.
Although you might simply feel better off because you have more interest coming in, with inflation still far higher than the Government’s 2% target, it’s important to earn as much interest as you can to try and mitigate the effects of the ongoing cost of living crisis. So, earn as much interest as you can – and don’t pay more tax than you need to!
Although this email and article may contain helpful information and tips, these are not personal advice. You may wish to seek advice from a financial advisor if you are unsure what’s best for your own personal circumstances.
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