Maximising your income by minimising your tax liability is being financially tax efficient. And, if you use all of your allowances, you’ll be doing so legitimately.
One such allowance is your personal savings allowance, which can be an effective way to shield your income from paying more tax than necessary.
What exactly is the personal savings allowance (PSA)?
The personal savings allowance is a tax-free allowance introduced in the UK in 2016. It works by giving individuals a certain amount of interest they can earn on their savings without paying any tax on it.
The amount of the PSA you receive depends on your income tax band or thresholds. You’ll need to know your tax band before calculating your tax-free savings. Significantly, savings interest is classed as income. You need to add it to your total earnings before determining what tax bracket you sit in. If your interest takes you into a higher bracket, you need to be aware of the impact on your PSA.
For basic rate taxpayers (those who earn up to £50,270 per year), the PSA is £1,000. For higher-rate taxpayers (those who earn between £50,271 and £125,140 per year), the PSA is £500. Additional rate taxpayers (those who make over £125,140 per year) do not receive a PSA.
The PSA applies to interest earned on savings accounts, bank accounts, building society accounts, and certain types of bonds. However, it does not apply to interest earned on ISA accounts, as the interest on these accounts is already tax-free.
If an individual earns more interest than their PSA, they must pay tax on the excess interest. Basic rate taxpayers will pay tax at 20% on the excess interest, while higher rate taxpayers will pay 40%.
It’s worth noting that the PSA is a personal allowance, which means couples who hold joint accounts can each claim their own PSA, effectively doubling the tax-free amount of interest they can earn on their savings.
Personal savings allowances vs Personal allowance
One of the reasons tax can be so difficult to understand is the jargon behind it. Specific to the personal savings allowance, one reason that it can be hard to understand at first is that it sounds so similar to ‘personal allowance’. Yet, they are two different concepts.
The personal allowance is the amount you can earn every tax year before paying taxes. For HMRC reporting purposes, your personal allowance refers to income earned as wages or salary. However, if you are a business owner, you’ll need to pay income tax on your business’s profits or tax on dividends over your dividend allowance.
For 2023/24, the personal allowance for most people is £12,570. However, you may have a slightly higher personal allowance if you can claim marriage or blind person’s allowance. Conversely, it may be lower if you’re a higher-rate taxpayer or still owe HMRC tax from previous years.
Calculating tax owed on savings interest
Any savings interest, or savings income, you earn from your savings accounts is included towards your personal savings allowance (PSA) until you go over your allocated amount.
As a result, when calculating what tax you must pay, you must remember all your accounts and the interest earned on them, as they will affect your PSA. If you have multiple savings accounts, the interest earned on every single one is added to determine if you have exceeded your PSA. For example, if you have two savings accounts with interest earnings of £600 each, your total interest earnings would be £1,200, which exceeds the £1,000 PSA for basic rate taxpayers. You can get an annual interest summary from your bank.
In addition, some types of savings income, such as income from fixed-term bonds or savings accounts with bonus interest rates, may be subject to tax at source, meaning that tax is deducted before the interest is paid to you. So, for example, if you earn £1,200 in interest on a savings account, but £200 tax is deducted at source, your PSA will only apply to the remaining £1,000 interest.
The starting rate for savings income
The starting rate for savings and the personal savings allowance are two different ideas that are closely related. But, again, it’s essential to understand both so you know what is taxable for your self-assessment.
The starting rate for savings is a special savings rate available to people who have a low income. If you are eligible, you can earn some savings income tax-free in addition to your Personal Savings Allowance (PSA). Currently, the starting savings rate is £5,000.
To be eligible, you must meet the following criteria:
- You must be a UK resident for tax purposes.
- You must have taxable non-savings income, such as employment or rental income, below the personal allowance for the tax year. Remember, for the tax year 2023/24, the personal allowance is £12,570.
- You must be a basic rate taxpayer, which means your taxable income is between £12,571 and £50,270 for the tax year 2023/24.
- Your savings income (such as interest from savings accounts, bonds, or other savings products) must not exceed the starting rate for the savings limit for the tax year.
Remember, eligibility criteria and the amount of tax-free savings income available may change each tax year, so it’s essential to check the HM Revenue & Customs (HMRC) website or consult a financial advisor for the latest information.
ISAs and your personal savings allowance
ISAs (Individual Savings Accounts) are a type of savings account in the UK that offer tax-free interest and gains on investments. Unlike non-ISA investments, ISAs have separate tax-free allowances and are not included in your personal savings allowance (PSA).
The annual ISA allowance is £20,000 as of the 2023/24 tax year, which means you can invest up to £20,000 in an ISA each year without paying tax on the interest earned or the gains made. You can split this allowance between different types of ISAs, such as cash ISAs, stocks and shares ISAs, innovative finance ISAs, and Lifetime ISAs.
ISAs do not affect your personal allowance for income tax purposes. For savers, then, using up your ISA allowance can be an effective way of shielding your interest earnings, particularly if you are going to go above your PSA.
Cash ISAs are most similar to regular savings accounts and offer a headline interest rate when you open an account. While that reliability coupled with tax efficiency is attractive to some, many are put off by the low rates that these products often have.
Due to the relatively low interest rates available with cash ISAs, many look to open Stocks and Shares ISAs, which are riskier products but offer uncapped return potential. In addition, investing in a Stocks and Shares ISA can be a particularly effective way to retain funds if you are trying to minimize the amount of tax owed because you will use up your PSA. Notably, the compound interest you earn can add up to significantly more than if it had been taxed.
A less well-known product, an innovative finance ISA offers access to more types of investable assets. Generally speaking, that will mean investments in peer-to-peer lending or crowdfunding, which will be protected from tax. This product type may be attractive if you want to invest in more asset classes to diversify your portfolio. However, the trade-off is increased risk.
Available to those between 18 and 39, if you open this type of account, you can get a 25% top-up bonus payment from the Government on savings up to £4,000. However, how you spend the money has strict criteria. For example, you must keep it in an account until you are 60 or use it to buy your first home.
You can get all these different types of ISAs from many providers. However, ensure they are overseen by the Financial Conduct Authority and the Prudential Regulation Authority to protect you from scams or negligent behaviour.
Investment types and your personal savings allowance
The PSA applies to interest earned and interest distributions on savings and cash investments such as:
- Bank and building society accounts – including current accounts, instant access savings accounts, and notice accounts.
- Life annuity payments and some life insurance contracts
- Open-ended investment companies, investment trusts and unit trusts.
- Peer-to-peer lending – interest earned from peer-to-peer lending platforms.
- Government bonds – including premium bonds and national savings and investment (NS&I) products.
- Corporate bonds – including bonds issued by companies.
- Certificates of Deposit – short-term fixed-rate savings products offered by banks and building societies.
- Money market funds – mutual funds that invest in short-term debt securities.
The PSA does not apply to income from other investments, such as dividend income from stocks and shares, property income, or income from rental properties. These types of income are subject to their own tax rules and regulations.
Do I need to declare savings interest to HMRC?
Yes, in most cases, you must declare savings interest to HMRC. This is because savings interest is seen as income and is subject to income tax.
If the total interest earned on your savings accounts exceeds your personal savings allowance (PSA), you must declare the excess interest to HMRC and pay tax on it. Most people will need to declare savings interest on their self-assessment tax return if they complete one. If you find yourself in this position, you could also ask HMRC or a tax advisor or accountant for other declaration options.
It’s essential to keep records of your savings interest earned, such as statements from your savings accounts or a summary of your interest earned for the tax year. This will help you accurately report your income to HMRC and avoid penalties for incorrect reporting.
If you have paid tax on your savings income but believe you should not have, you may be able to claim a refund from HMRC.
The circumstances in which you may be able to claim a refund include:
- You have not exceeded your Personal Savings Allowance (PSA) or Starting Rate for Savings allowance but paid tax on savings interest.
- You have overpaid tax on your savings income due to an error, such as your bank or building society not correctly applying your tax code or not deducting tax at the correct rate.
To claim a refund, you can contact HMRC directly or use their online services to submit a claim. To support your claim, you must provide evidence of the tax paid on your savings income, such as bank statements or savings account statements.
There may be time limits for claiming a refund, so it’s best to do so as soon as possible. You should also be aware that HMRC may conduct an investigation to verify your claim and could request additional information or documentation. It’s always a good idea to consult a financial advisor or tax professional for assistance with making a claim or dealing with HMRC.
The personal savings allowance
As with anything tax related, the personal savings allowance can seem a little complicated when you first read about it. However, it will become clearer the more self-assessments you do or the more work you complete with a tax advisor or accountant. The critical thing to remember is to keep informed about how much the allowance currently is – especially if you complete your own self-assessment – and keep tabs on your investments that attract interest.