It’s important to maximize income by making the most of Government allowances. While you can find these on the GOV.UK website, they’re not always easy to understand. Yet, knowing how to make your money work harder for you now is crucial, especially if you are saving for retirement and need to supplement your state pension.
Earning interest is a great way to make your money stretch further, so keeping as much of it free from tax can help compound gains.
The personal savings allowance (PSA) is tax relief offered to individuals in the United Kingdom on the interest they earn from their savings. It was introduced in April 2016 and means basic rate taxpayers can earn up to £1,000 in interest without paying any tax. And higher rate taxpayers can earn up to £500 interest tax-free. Additional rate taxpayers are not eligible for the personal savings allowance.
If you earn savings interest, you may not need to pay any tax on the first £1,000 or £500, depending on your tax bracket. It’s important to note that the personal savings allowance is not a separate allowance you must claim. Instead, it is automatically applied to your savings income, so you don’t need to do anything to benefit from it. However, if you earn more than the PSA in interest, you must pay tax on the excess.
What is savings interest?
HMRC counts the following investments and savings accounts as ones that earn savings interest subject to tax (once over the PSA):
- Bank accounts
- Savings accounts
- Credit union accounts
- Building societies
- Corporate bonds
- Government bonds (including national savings and investment (NS&I) products
- Peer-to-peer lending
- Interest distributions from authorized unit trusts, open-ended investment companies, and investment trusts
- The majority of purchased life annuity payments and some life insurance contracts
Interest earned in UK-based savings accounts on cash held in other currencies is also subject to tax. However, you do get a separate allowance for dividend income from stocks and shares.
The dividend allowance is different to savings allowances as HMRC perceives this particular source of income as separate. As such, it can be a great way to earn more income, which is also shielded from tax in any tax year. But what exactly is it?
The dividend allowance is the dividend income an individual can receive each tax year without paying any tax on it. It was introduced in the UK in April 2016 and applies to all taxpayers, irrespective of their tax band.
In the 2023/24 tax year, the dividend allowance is £1,000, so you can earn up to £1,000 in dividends without paying any tax on it. If an individual receives more than £1,000 in dividends, they must pay tax on the excess amount at the applicable dividend tax rate.
The dividend allowance is separate from an individual’s personal allowance, which is the income they can earn each year without paying any tax. The current personal allowance for the tax year 2023-24 is £12,570. Those who are self-employed often pay themselves a salary up to £12,570 and then pay themselves in dividends, given that dividend tax rates can be a more tax-efficient way to be paid, as shown in the table below:
|Thresholds 2023/24||Dividend Tax Rate 2023/24|
|Personal Allowance: no tax payable on income in this band.||£0 – £12,570||0%|
|Basic-rate taxpayers||£12,571 – £50,270||8.75%|
|Higher-rate taxpayers||£50,271 – £125,140||33.75%|
|Additional-rate taxpayers||£125,140 upwards||39.35%|
ISAs and tax-free savings
While you may need to pay tax on interest if you go over your PSA, you don’t pay any tax on interest with Individual Savings Accounts (ISAs). They’re tax-efficient savings or investment accounts available to UK residents. There are several types of ISA, including cash ISAs, stocks and shares ISAs, innovative finance ISAs, and lifetime ISAs.
However, you can only invest so much in an ISA each tax year. For the tax year 2023/4, the annual ISA allowance is £20,000, meaning you can invest up to this amount across all types of ISAs in a tax year. However, the tax benefits of ISAs may be subject to change depending on changes in tax legislation, so seek professional advice if necessary.
That said, as ISAs are currently a tax-efficient way to shield your savings and investments from tax, it’s essential to understand what they are and the types available.
Cash ISAs are almost like savings accounts. They typically offer a variable or fixed interest rate, with that interest not subject to income tax, saving account holders money. So, when you withdraw money from a cash ISA, you won’t have to pay tax on what you take out.
However, while Cash ISAs offer tax-free savings, their interest rates may not always be the highest available in the market. Therefore, comparing different Cash ISA products is essential to find the best interest rate and terms to suit your savings needs.
Stocks and Shares ISAs
A Stocks and Shares ISA is an investment account allowing you to invest in stocks, shares, funds, and other investment products. As with a cash ISA, you don’t need to pay tax on withdrawals from a Stocks & Shares ISA.
You don’t pay income or capital gains tax on the returns you earn from a Stocks & Shares ISA. Best of all, those returns are uncapped.
However, while Stocks and Shares ISAs can offer potentially higher returns than Cash ISAs, they come with higher risk as the value of investments can fluctuate based on market conditions. So you must consider the risks and benefits of Stocks and Shares ISAs and seek professional advice if necessary, especially if you are a first-time account opener.
An innovative ISA refers to a type of tax-efficient investment account that allows individuals to invest in many more types of assets than traditional ISA accounts.
Innovative ISAs typically provide investment opportunities in areas like peer-to-peer lending, crowdfunding, and social impact investing. These investments often come with higher risk but can offer potentially higher returns.
Innovative ISA providers are regulated by the Financial Conduct Authority (FCA), and you should carefully consider the risks involved before investing. An innovative ISA is an alternative option for diversifying your investment portfolio beyond traditional stocks, bonds, and cash holdings.
Lifetime ISAs provide a tax-efficient way to save money for your first home or retirement. The account is available to individuals aged 18-39 and offers a 25% government bonus on savings up to £4,000 per year, so you can receive up to £1,000 in bonuses annually. The savings can be invested in cash, stocks and shares, or both.
You must meet certain conditions must to qualify for the government bonus. For example, you must use the money to purchase a first home worth up to £450,000 in the UK or keep it in the account until you reach 60.
Withdrawals before the age of 60 for any reason other than buying a first home or in the case of terminal illness can result in a penalty charge and loss of the government bonus. Therefore, it is essential to consider eligibility and the terms and conditions of a lifetime ISA before opening one.
The problem with the ISAs above is that if you need to withdraw money, you can’t put it back in without it contributing to your allowance again. As a result, there may be better ways for you to invest, regardless of the tax saving.
A flexible individual savings account, or flexible ISA, is another type of tax-free savings account available to residents of the United Kingdom. The flexible ISA allows you to withdraw money from your account and replace it in the same tax year without affecting your annual ISA contribution limit.
For example, if you have saved the maximum amount allowed in your ISA for the tax year (£20,000 as of the 2023/24 tax year) but then withdraw £5,000 from your account, you can replace that £5,000 within the same tax year without it counting towards you annual contribution limit. This allows for greater flexibility in managing savings and investments.
One major stipulation with most flexible ISAs is that you must replace any money you withdraw in the same account. However, there are times when you can withdraw from a flexible cash ISA and replace it in a flexible stocks and shares ISA or even a flexible innovative finance ISA. Ensure you read the product details before you open one of these accounts.
Remember that not all ISAs are flexible. In fact, they are currently less common. So, it’s essential to check the terms and conditions of an individual savings account before making withdrawals or contributions to ensure it has the flexible ISA feature.
How tax is calculated on savings account interest
While it’s good to know how much interest is tax-free in any given tax year, it’s also worth understanding how the tax on interest earned on savings is calculated. Doing so means you can make better-informed decisions about where and how to invest, earn, or spend your money.
Tax on interest is calculated based on your taxable income, your personal savings allowance, and the tax rate that applies to that income. Remember, currently, for the tax year 2023/24, the PSA is £1,000 if you are a basic rate taxpayer and £500 if you are a higher rate taxpayer. Additional rate taxpayers don’t receive a PSA.
You only pay tax on interest if your savings income exceeds your PSA for the tax year. Current tax rates are:
- Basic rate taxpayers (taxable income up to £50,270 for 2023/24) pay 20% tax on the excess interest.
- Higher rate taxpayers (taxable income between £50,270 to £125,140 for 2023/24) pay 40% tax on the excess interest.
- Additional rate taxpayers (taxable income above £125,140 for 2023/24) pay 45% tax on the excess interest.
Tax rates and thresholds may change each tax year, so always check the latest information from HM Revenue & Customs (HMRC) or consult a financial advisor. Seeking financial advice can help you use every tax allowance possible, maximizing your tax relief and lowering the tax you pay.
The starting rate and tax-free interest
For some on a low income, the interest they can earn tax-free is much higher than the PSA. It’s known as the starting rate for savings and is currently set at 0% for up to £5,000 of savings income. It means that if you earn up to or less than the personal allowance and have savings income below £5,000, you may be eligible for this starting rate of savings tax.
Banks once took the tax directly at the source. However, since 6 April 2016, banks and building societies have paid any interest gross, which means they do not deduct income tax.
Yes, you generally need to declare savings interest to HM Revenue and Customs (HMRC). Interest earned on your savings is considered income and may be subject to tax.
However, if the interest you earn on your savings is within the amount covered by your personal savings allowance, you should find your allowance is automatically applied. If you exceed your PSA, you must declare the interest earned on your savings as part of your overall income on your self-assessment tax return. You must calculate how much interest you have made from your savings accounts, including any joint accounts, and declare the total amount on your tax return. HMRC will then use this information to determine how much tax you owe on your savings income.
If you are unsure what to do for your self-assessment, seeking the advice of an accountant and a financial advisor can be helpful. They’ll ensure that you submit an accurate record of your annual income and can help minimize your tax liability.
How does HMRC know what savings you have?
HM Revenue and Customs (HMRC) receives information about your savings interest from banks, building societies, and other financial institutions through the Common Reporting Standard (CRS). The CRS requires financial institutions to report information about their customers’ financial accounts to the tax authorities of the country where the account holders are residents for tax purposes.
HMRC can therefore receive information about the interest you earn on your savings accounts, including the name of the financial institution, the type of account, and the amount of interest earned. They use that information to ensure individuals pay the correct tax on their savings income.
HMRC can also request information directly from you about your savings income as part of a tax investigation or compliance check. For example, a check may involve asking you to provide bank statements, interest certificates, or other documents that show how much interest you have earned on your savings accounts. Do be careful of any scams, however, and only respond to requests that you know are genuine.
It’s crucial to keep accurate records of your savings income and to declare any interest earned on your tax return, even if HMRC does not have access to the information through the CRS. Failing to report savings income can result in penalties and interest charges and potentially trigger a tax investigation.
If you have already paid tax on your savings, such as interest earned from a non-ISA savings account or another taxable source, you may be able to reclaim the overpaid tax. Here are some steps you can take.
Check your tax status
Ensure you know your current tax status and whether you have exceeded your PSA for the tax year.
Review your tax documentation, such as your bank statements and savings account interest statements, to determine if you have paid tax on your savings income.
If you believe you have overpaid tax on your savings, contact HMRC. You can contact them through their website, phone, or mail to request a refund of the overpaid tax. Provide them with the relevant details, including your personal information, income details, and evidence of the tax paid on your savings.
Keep copies of all communication and documentation related to your tax refund claim, including any correspondence with HMRC and evidence of tax paid on your savings.
If you require assistance, seek professional advice from a qualified tax advisor or accountant to ensure you follow the correct procedures and maximise your chances of reclaiming overpaid tax. Tax rules and regulations can change, and reclaiming overpaid tax on savings can be complex. Therefore, consulting with a tax professional may be worthwhile.
The world of savings and savings products can be a complicated place. When deciding where to save or invest your cash, consider the tax implications. To do so, you must first understand how much interest is tax-free.
Taken all at once, though, it can be overwhelming looking at the options and allowances available to you to be tax-efficient. However, bear in mind that with the average interest rate on savings accounts, you’d need at least £10,0000 in savings before you even go over your PSA – and that’s if you are a high-rate taxpayer. If you’re a basic rate taxpayer, making use of an easy access account that pays around 3.5%, you’d need over £28,000 saved before having to make tax payments on the interest you earn. Plus, ISA limits are pretty generous for a large section of the UK population.
As such, doing all three of going over your PSA, using up your ISA allowance, and exceeding your dividend allowance is unlikely.