Understanding the personal savings allowance and tax on interest
For many people in the UK, earning interest on their savings is a welcome boost to their finances. However, it’s important to understand that this interest is not always tax-free. The rules around when you need to pay tax on your savings interest can be confusing, and a misunderstanding could lead to an unexpected tax bill from HMRC. This guidance explains how the Personal Savings Allowance works, who it applies to, and what you need to be aware of to stay on the right side of the tax rules.
What is the personal savings allowance?
The Personal Savings Allowance (PSA) is a tax-free allowance for the interest you earn on savings. It was introduced to simplify the tax system for most savers. Crucially, it is not an additional allowance you apply for; it applies automatically. The amount of allowance you get depends on which income tax band you fall into.
For the current tax year, the allowances are:
- Basic-rate taxpayers: You can earn up to £1,000 in savings interest tax-free.
- Higher-rate taxpayers: You can earn up to £500 in savings interest tax-free.
- Additional-rate taxpayers: You do not get a Personal Savings Allowance. All your savings interest is taxable.
Your tax band is determined by your total taxable income, which includes your salary, pension, and any other income, plus the savings interest you earn. It’s important to note that if your savings interest pushes your total income into a higher tax band, your PSA may be reduced.
How does HMRC know about my savings interest?
UK banks and building societies automatically report the interest they pay you directly to HMRC. This system means HMRC has a record of your interest income. For most people, the tax due on savings interest is collected automatically through your PAYE tax code if you are employed or receive a pension. If you complete a Self Assessment tax return, you must declare any interest that exceeds your PSA on your return.
What counts towards the allowance?
The PSA applies to the interest earned on most standard savings products held by individuals. This includes:
- Interest from easy-access savings accounts.
- Interest from fixed-rate bonds.
- Interest from notice accounts.
- Interest from current accounts that pay interest.
- Income from peer-to-peer lending (though this has its own specific tax treatment).
It does not apply to interest earned within an Individual Savings Account (ISA). All interest earned in a Cash ISA is completely tax-free, regardless of your tax band, and does not count towards your PSA.
Common pitfalls and what to watch out for
Many people are caught out because they don’t actively track their savings interest across multiple accounts. With savings rates rising, it’s easier than ever to exceed your allowance unintentionally. Here are the key risks to be aware of:
1. Forgetting about old accounts
You might have an old savings account from years ago that is now paying a higher rate of interest. Even if you don’t actively use the account, the interest it generates still counts towards your PSA and your total income.
2. Joint accounts
For joint savings accounts, the interest is typically split 50/50 between account holders for tax purposes. Each person’s share of the interest counts towards their own individual PSA.
3. The ‘starting rate’ for savings
There is an additional allowance called the ‘starting rate for savings’. If your other taxable income is below the Personal Allowance (£12,570), you may be eligible for this starting rate of up to £5,000. This can work alongside your PSA, but the rules are complex. If your non-savings income is close to the Personal Allowance, it’s worth checking how this interacts with your PSA.
4. Rising interest rates
As savings rates increase, the amount of interest you earn on a given balance grows. A pot of £50,000 earning 5% generates £2,500 in interest. This would exceed the PSA for both a basic-rate and higher-rate taxpayer, resulting in a tax liability.
What happens if I exceed my allowance?
If the interest you earn across all your non-ISA savings exceeds your Personal Savings Allowance, you will have to pay tax on the excess. The rate you pay is the same as your marginal income tax rate (20% for basic-rate, 40% for higher-rate, 45% for additional-rate).
HMRC will usually adjust your tax code for the following year to collect the tax owed, spreading the cost. If the tax owed is significant or you complete a Self Assessment, you may need to pay it directly. It is your responsibility to ensure your tax affairs are correct, so keeping a record of interest from all your accounts is good practice.
How can I avoid tax on my savings interest?
The most straightforward way to avoid tax on savings interest is to use your annual ISA allowance. In the 2024/25 tax year, you can save up to £20,000 into ISAs. Any interest or growth within an ISA is shielded from tax permanently. Spreading savings between yourself and a lower-earning partner can also be a tax-efficient strategy, as they may have a larger unused PSA or be a non-taxpayer.
In summary, the Personal Savings Allowance provides valuable tax-free interest for many, but it has limits. Savers should be mindful of their total interest earnings, especially in a higher-rate environment, and consider using ISAs to protect their returns from tax. Keeping track of all your accounts and understanding how your tax band affects your allowance are crucial steps to managing your savings tax efficiently.
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Source:
https://www.getsurrey.co.uk/news/cost-of-living/savings-hmrc-warning-many-dont-33570590
