Savers may be hit with tax on savings for first time as rates rise

by | Oct 4, 2022

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Written by Laura Suter, head of personal finance at AJ Bell

The rates war in the savings market is great news for those with cash stashed away, but many will be hit with an unexpected tax bill as a result of getting a better return on their savings.

The Personal Savings Allowance gives basic and higher rate taxpayer a tax-free allowance for their savings income, but rising interest rates mean that many will breach it for the first time.

On top of this, because income tax allowances have been frozen, more people are being pushed into the next tax bracket and so seeing their Personal Savings Allowance chopped in half or disappear altogether. Basic-rate taxpayers can earn £1,000 on their savings before being taxed, while higher rate taxpayers get a £500 limit and additional rate taxpayers get no tax-free allowance.

When base rate was 0.1%, if your savings were earning that amount of interest, a basic-rate taxpayer would need to have £1 million in cash savings to hit their £1,000 tax-free limit. However, fast forward to today and with the top easy-access savings account now paying 2.35%* that same basic-rate taxpayer would only need to have £42,500 in savings to hit the limit. What’s more, if that basic-rate taxpayer had seen their income rise in the past few years and had tipped over into the higher-rate income tax bracket, they would only have a £500 tax-free savings limit, meaning they would need to have £21,250 in savings before they hit their new, lower limit.

Those putting their money in fixed rate accounts are getting far higher rates, but this means they face a tax hit even with more modest savings. The top two-year bond at the moment pays 4.5%*, meaning a basic-rate taxpayer with £22,200 would hit their tax-free limit, while a higher-rate taxpayer could only have just over £11,000 before they would have to pay tax.

Even savers who are still within their tax-free limits now need to be mindful of potentially hitting them in this tax year. Interest rates are expected to rise further from here. If Base Rate hit the 6% it’s expected to next year and easy access savings rates matched that, a basic-rate taxpayer could only have £16,650 in their account before they hit the limit – and for a higher-rate taxpayer this would drop to £8,300.

The solution for savers who think they will be caught in this tax trap is to put their money into an ISA. We saw cash ISA use fall off a cliff after the Personal Savings Allowance was launched in 2016, but we’re going to see a boom in ISAs this tax year, as more savers try to shelter their money from the taxman.

Each individual can put up to £20,000 into an ISA each year, but they just need to check they haven’t made any contributions so far this year into any other ISAs. However, cash ISAs often pay lower interest rates, so savers will need to do their sums to work out whether it’s worth picking a higher paying non-ISA account and paying tax on their savings interest, or putting it in an ISA and accepting a lower rate.

How much can savers have before hitting their tax-free limits?

Account Rate Amount basic-rate taxpayer can have before hitting the limit Amount higher-rate taxpayer can have before hitting the limit
Top easy-access account December 2021

0.65%

£154,000

£77,000

Top easy-access account October 2022

2.35%

£42,500

£21,250

1-year fixed rate

4.11%

£24,350

£12,175

2-year fixed rate

4.50%

£22,200

£11,100

Expected rates next year

6%

£16,650

£8,325

Source: AJ Bell. Best buy rates data based on Moneyfacts, accurate to 4th October 2022

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