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Have you checked the interest rate on your savings account(s) lately? With easy-access rates now paying over 3%, anyone paying below 2.9% could benefit by shopping around. Interest rates on savings have tripled over a 12-month period, yet many savers are still not getting the best deal (especially those with cash ISAs, which tend to offer lower rates compared to regular accounts). Yet there is a hidden danger with the new rise in UK interest rates. Below, we show how the “tax trap” on cash savings can trip people up. We also offer ideas to help avoid this in your own finances. We hope this content is useful to you. If you want to discuss your own financial plan with us, please contact our team for more information or to access personalised financial advice:
020 8366 4400 or enquiries@cedarhfs.co.uk
Which taxes apply to UK cash savings?
If your income is under £17,570 per year then you do not pay any tax on interest up to £5,000. Those earning over this are entitled to a Personal Savings Allowance (PSA) which varies depending on your income. For the basic rate taxpayer the PSA is £1,000 per tax year; for the higher rate taxpayer the PSA is £500. Above these thresholds, your pay tax on your interest (e.g. from cash savings or bond income) equivalent to your highest marginal rate of income tax. Bear in mind that interest earned within an ISA (e.g. a cash ISA) is not subject to income tax and does not count towards your PSA.
Why is there a “tax trap” on savings in 2023?
The Bank of England (BoE) has raised interest rates by 4.15 percentage points since December 2021, now standing at 4.25% (the highest since October 2008, following the onset of the 2008 Financial Crisis). When the BoE raises its rates other UK banks follow suit with their own rates – pushing them up on new product deals such as savings accounts and mortgages. In April 2023, therefore, it is possible to now find savings deals at 3.55% easy-access or at 4.65% fixed. The rates are the highest they have been in years (although they still do not beat the current rate of UK inflation at 10.4%, meaning they still currently lose value in real terms).
Whilst higher interest rates are certainly welcome for those with cash savings, there is now a greater risk that some people will inadvertently breach their tax-free PSA. For instance, in March 2021 a higher rate taxpayer would likely have kept within his PSA if he had as much as £86,000 invested in a best-buy one-year bond (outside of an ISA). In September 2022, however, after a string of interest rate increases, the tax-free limit would have been closer to £14,000.
How do I avoid the tax trap on cash savings?
Firstly, consider speaking with a financial adviser if you are concerned about how tax may erode your returns from interest earned. A professional can help you organise your affairs optimally in light of your goals and circumstances. However, we can offer some ideas to discuss with them during a potential meeting. For instance, do you have a spouse or civil partner? If they earn less than £17,570 per year or do not work, then they can earn up to £5,000 per year from interest and not pay income tax. If you are nearing your PSA limit (e.g. £500 if you pay the higher rate), then transferring certain assets to your partner/spouse could help to reduce your overall tax bill on your household. Remember, you can make transfers like this between the two of you without a tax liability if you have lived together for at least some time in the tax year of the transfer. This tax benefit is not available to cohabiting partners who are unmarried or not in a civil partnership.
Another idea is to move interest-paying assets into an ISA when the total earned is nearing your PSA in the tax year. In 2023-24 you can commit up to £20,000 into your ISAs and any interest earned inside will be tax-free. Your spouse/civil partner is also entitled to their own £20,000 ISA allowance, so you could also make transfers to take advantage of unused ISA allowance before the tax year-end. However, be careful about putting too much cash into your ISAs. Interest rates still do not beat inflation in 2023. Generally, it may be wiser to focus your ISAs on assets which offer higher potential returns (e.g. shares) – also allowing for tax-free capital gains.
Premium Bonds could be another option. Here, your PSA does not apply as Premium Bonds offer the chance of winning a monthly cash prize instead of a guaranteed interest rate. You can hold up to £50,000 in Premium Bonds in 2023-24. The more you hold, the higher your chances of winning a prize (although the odds are still very low). Premium Bonds can be accessed just as fast as cash savings. As such, they can be used as a storage place for an emergency fund whilst also potentially helping to mitigate a tax bill on your interest.
Conclusion
Interested in discussing your financial plan with an experienced financial adviser? Get in touch today to discuss your financial plan with a member of our team here at Cedar House via a free, no-commitment consultation:
020 8366 4400 or enquiries@cedarhfs.co.uk