Beware of taxes on higher savings rates
This content is for information purposes only and should not be taken as financial advice. Every effort has been made to ensure the information is correct and up-to-date at the time of writing. For personalised and regulated advice regarding your situation, please consult an independent financial adviser here at Castlegate in Grantham, Lincolnshire or other local offices.
UK interest rates have risen 7 times since late 2021, from a historic low of 0.10% to 2.25% at the time of writing. The Bank of England’s (BoE’s) decision to do this has led other banks to raise their own interest rates, not just for variable mortgages (and new fixed-rate deals) but also for savings accounts. The latter is certainly welcome, but the higher rates offered by many cash accounts now risk inadvertently driving more savers into paying tax on their interest. Below, our Lincolnshire financial planners at Castlegate explain why this is happening and how savers can navigate higher savings rates wisely. We hope you find this content helpful. If you want to discuss your own financial plan with us, please get in touch to arrange a no-obligation financial consultation, at our expense:
01476 855 585
info@casfin.co.uk
Why could more savers pay tax on their interest?
In recent years, interest rates offered by regular savings accounts have been historically poor. In December 2021, the best easy-access account only offered 0.75%, but the average rate was a measly 0.19%. Under this 0.75% savings rate above, a saver would need about £66,666 to generate £500 per year in interest. This is the threshold at which a Higher Rate taxpayer uses up his/her tax-free Personal Savings Allowance and interest starts to be taxed. For someone on the Basic Rate, up to £1,000 can be earned in interest each tax year without tax under the Personal Savings Allowance (PSA).
However, with the BoE raising interest rates in 2022, other banks have also been raising rates on mortgages and savings accounts. Today, a competitive easy-access account offers around 2.21% and a strong fixed-rate deal at 3.75%. Whilst earning more interest is undoubtedly appealing to savers, there is now a risk that more people inadvertently breach their PSA. For instance, a Higher Rate taxpayer with a 2.1% easy-access account could now start paying income tax on their interest once the savings exceed £23,800 (not £66,666 as in the 0.75% case above). Additionally, it is possible that the tax-free threshold could drop even further. For instance, if the BoE raises interest rates to 3.75% by the end of the year (as many expect), then a Higher Rate taxpayer may start paying tax on interest from savings over £13,000.
How to protect your savings from tax
First of all, bear in mind that income tax allowances have also been frozen until 2025/26. This is expected to push 1.2m more people into the Higher Rate by 2026. This means that many could unknowingly see their PSA reduced from £1,000 per year to £500, with any interest above their threshold taxed at 40% rather than 20%. Be careful to review your tax plan with your financial adviser if you think you may be affected. There are legitimate ways to avoid being a casualty of the income tax freeze, such as making pension contributions from income over £50,270.
Secondly, remember that savings rates in 2022 still offer a poor deal when considered in light of inflation. At present, Consumer Price Index (CPI) inflation stands at 10.1%, meaning that even cash in a 4.61% fixed-deal account would still incur a 5.49% “real terms” loss. As such, cash is still a poor asset class for building long-term wealth. Rather, it is better used for purposes such as building an emergency fund (e.g. 3-6 months’ worth of living costs). For instance, someone with £2,000 monthly living costs may only need £12,000 in easy-access cash savings. In which case, this could keep a Higher Rate taxpayer’s savings free from tax on interest if the BoE puts the base rate up to 3.75%.
What if you need to hold an amount of cash which is likely to take you over your PSA? Here, it can help to explore options with a financial adviser. One idea is to use some of your £20,000 annual ISA allowance. Any cash held inside generates interest without tax. However, you need to consider whether your ISA allowance is better used towards other assets which offer higher potential returns (e.g. shares, which will generate tax-free capital gains and dividends inside an ISA). Another option is to invest some of your cash into Premium Bonds. Since these do not generate any interest (rather, a prize draw is offered), any returns you generate will not count towards your PSA. You can also cash in your Premium Bonds easily and quickly at any time with no penalty, which means they could be used for your emergency fund.
Invitation
If you are interested in discussing your own financial plan or investment strategy with us, please get in touch to arrange a no-commitment financial consultation at our expense:
01476 855 585
info@casfin.co.uk
