Interest rates have risen – could you now be paying tax on your savings?

23/08/2023

On 3 August 2023, the Bank of England (BoE) raised its base rate to 5.25%, marking a 14th consecutive increase as the Bank tries to slow inflation.

Increasing the base rate is one of the BoE’s main tools for trying to control inflation, limiting consumer spending and encouraging saving. A higher base rate typically makes borrowing for mortgages and loans more expensive, while increasing the rates you might see on savings accounts.

Generally, increased borrowing rates are a negative, as it can make repaying money more expensive. This often leads individuals to reduce their expenditure, as they typically have less disposable income.

Meanwhile, rising savings rates is typically positive, as it means you can generate more interest on your cash. In turn, this encourages you to save your money rather than spend, ideally slowing inflation.

That said, a knock-on effect of rising interest rates is that it might mean you find yourself having to pay tax on your savings interest for the first time in a while.

So, learn why, what you may be able to do to reduce your tax liability, and how working with Douglas White Financial Planning (DWFP) can help.

You can earn interest tax-free up to certain limits

The reason that you may start paying tax on your interest now when you weren’t before is to do with a tax-free threshold called the Personal Savings Allowance (PSA). This allows you to earn a certain amount in interest before Income Tax is due on it.

In the 2023/24 tax year, the PSA is:

  • £1,000 for basic-rate taxpayers
  • £500 for higher-rate taxpayers
  • £0 for additional-rate taxpayers.

When interest rates are lower, as they have been over the past couple of years, you’re less likely to breach the PSA unless you are holding particularly substantial amounts of cash.

But, as rates increase and you generate more interest, you may be more likely to pay tax.

Moneyfacts shows the highest easy access savings account to have an interest rate of 4.83% as of 22 August 2023.

Any interest you earn above £1,000 as a basic-rate taxpayer becomes liable for Income Tax at 20%. That means you’d only need to hold £20,750 before your interest could become taxable.

With a PSA of just £500 for higher-rate taxpayers, this figure falls to just £10,375. If you pay additional-rate tax, you’ll have to pay 45% tax on all savings interest.

So, as you can see, rising rates could mean you have to pay more tax, or that you will exceed your PSA faster than you might have in previous years.

You may be eligible for the “starting rate for savings”

It’s worth noting that you may also be eligible for the “starting rate for savings”, if you have an income of less than £17,570.

In this case, you may be able to earn up to a further £5,000 in savings before Income Tax is due. You’ll receive the full £5,000 starting rate for savings if you have income below the Personal Allowance – the threshold before Income Tax is payable – of £12,570.

Your starting rate for savings will then reduce by £1 for every £1 of income over the Personal Allowance.

In total, that means you may be able to earn up to £6,000 in interest before tax is due in addition to the £12,570 Personal Allowance, if you are able to make use of the basic-rate PSA and the full starting rate for savings.

This can be particularly useful for couples where one of you is not working – keep reading to see a case study of where we helped one couple make the most of their allowances.

You can limit how much tax you might have to pay on your savings

Fortunately, there are various methods you can employ to limit the tax you might have to pay on your savings.

For example, you could save your money in a Cash ISA. All interest generated in a Cash ISA is entirely free from Income Tax.

In the 2023/24 tax year, you can save up to £20,000 each tax year in an ISA. Bear in mind that this limit applies across all ISAs you may hold.

Alternatively, you could save into your pension instead. Any money you hold in your pension can grow free from Income Tax and CGT. Furthermore, you’ll receive tax relief at your marginal rate of Income Tax up to the Annual Allowance – this is £60,000 or 100% of your earnings, whichever is lower.

It’s important to remember that you typically won’t be able to access the money in your pension before age 55, rising to 57 in 2028. As such, it’s often sensible to only contribute money you won’t need to rely on in the short term.

Of course, these are just two options, and there may be other ways for you to reduce the tax you may pay on your savings.

We can help to make your wealth even more tax-efficient

Alongside the options above, there are also more innovative solutions that can help you to make your wealth as tax-efficient as possible.

We recently worked on a case like this at DWFP. Our clients, Mr and Mrs X, were concerned about the possibility of having to pay tax on their savings.

Mr X is already retired, while Mrs X is working in a senior role and is an additional-rate taxpayer. Currently, they are living on Mrs X’s income, leaving Mr X’s pension untouched for the time being.

They have a joint savings account with around £100,000 in it. As it is in both their names, any interest generated is split between them.

As he currently has no income, Mr X has the basic-rate PSA and the full starting rate for savings. However, Mrs X is an additional-rate taxpayer, so she’ll face 45% tax on her share of the savings interest.

That means if they receive a 5% interest rate on their £100,000, that gives them £5,000 in interest a year – or £2,500 each. Mr X’s half is tax-free, as it is covered under the PSA and the starting rate for savings. But for Mrs X, she’ll pay 45% Income Tax on it.

To help Mr and Mrs X, we created a tax-efficient strategy that reorganises their wealth to reduce their tax liability, without affecting their lifestyle.

This strategy had three key stages:

  • Firstly, we recommended that Mr X begin drawing £16,760 a year from his pension. This means he is drawing just enough to remain within the Income Tax Personal Allowance of £12,570, with the remaining income using his 25% pension tax-free lump sum. As a result, he pays no Income Tax on this withdrawal. Furthermore, thanks to this tax position, he can generate £6,000 in interest before having to pay Income Tax – that’s £1,000 from his PSA, plus £5,000 from the starting rate for savings.
  • Next, we suggested holding savings in Mr X’s name, as he is in a lower tax band. With the 5% interest rate and his £6,000 tax-free threshold, that allows him to hold up to £120,000 in savings before tax is payable.
  • Finally, with their income now partially coming from Mr X’s pension, we suggested that Mrs X puts a further £20,000 of her income into her pension. With basic-rate tax relief making this £25,000 gross, and another 25% claimed at additional rate, this is a highly tax-efficient contribution.

Theoretically, these steps mean that Mr and Mrs X can continue to live the lifestyle they’re currently enjoying, making use of the available allowances while reducing their net household tax bill.

Restructuring the way they hold their shared wealth means there’s no impact on their ability to spend, either.

Speak to us.

If you’d like to learn more about how rising interest rates could affect you, or want to find out how you could reduce your tax liability, please get in touch with us.

Email info@douglaswhiteltd.com or call 0151 345 6828 to speak to an experienced adviser.

Please note

This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.

The Financial Conduct Authority does not regulate tax planning.