Recent data from HM Revenue and Customs (HMRC) shows that people are probably not doing enough to avoid paying tax on their savings interest.
For the 2023/24 tax year the amount of Income Tax collected from UK savers was around £6.6billion. This is nearly double the amount collected in 2022/23.
What’s more, HMRC predict that the amount collected for the 2024/25 tax year will be around £10.4billion.
This is tax you may be paying on the interest you earn on your cash savings.
You do not need to leave your cash savings exposed in this way as there are plenty of valid, legal ways to avoid paying tax on your savings interest.
Why You Need To Avoid Paying Tax On Savings Interest
Let’s just remind ourselves how tax works on savings interest.
When your bank pays you interest on the cash you hold with them, that interest payment is potentially subject to Income Tax.
Before 6th April 2016, banks paid interest with an automatic deduction for basic rate Income Tax. So, you would have received your interest net of basic rate tax.
Since 6th April 2016, banks have paid interest gross. So, there is no automatic deduction for any Income Tax, you receive the full amount of interest.
At the same point in time a new Personal Savings Allowance was bought in.
It allows you to earn up to £1,000 of interest tax free if you are a basic rate Income Tax payer and £500 tax free if you are a higher rate Income Tax payer.
There is no Personal Savings Allowance if you are an additional rate Income Tax payer.
Banks now report all of your interest payments to HMRC, so they know what interest you have been paid.
There is also further relief for savers who have little or no income by way of the starting rate for savers.
If your income from other sources like employment or pensions is below £17,570 then you could potentially earn up to £5,000 in savings interest tax free.
The £5,000 starting rate reduces by £1 for every £1 you earn over the Personal Allowance of £12,570.
So, for example, someone who earns income from a job of £14,000 could receive a further £3,570 in savings interest without paying tax on this interest.
Plus, they would still have their Personal Savings Allowance as well.
The reason why recent HMRC tax receipts from savings interest is increasing and expected to increase further is two-fold.
HMRC have said: “Income from savings is significantly more in 2024 to 2025 (approximately six times greater than 2021 to 2022), largely due to the actual and forecasted changes in bank and building society interest rates following the large reductions in bank and building society interest rates up to the end of 2021”.
As we all know interest rates on savings were low for a long time, so now they have increased, it’s only natural that tax revenue will increase.
However, there is a second factor as well and this is the frozen Personal Allowance. This is the amount of money you can earn before paying any Income Tax.
From the period 2014/15 to 2021/22 the Personal Allowance increased from £10,500 to £12,570. An average yearly increase of 3.06%.
Since 2021/22 the Personal Allowance has remained frozen at £12,570 and is currently scheduled to remain that way until 2026.
Had we continued the average increases since 2014/15 the Personal Allowance should now be £13,758 and £14,179 by the time we get to 2026.
Earnings from work and State Pension will generally increase each year to help cover the rising cost of living.
So, this type of income is taking up more and more of the Personal Allowance and beyond leaving no room for income earned from savings interest.
This in turn pushes everything up the tax bands. So, if you’re a basic rate taxpayer and paid more, you might find yourself falling into the higher rate tax bracket and some higher rate taxpayers might fall into the additional rate bracket.
Earnings are taxed first, so savings interest is added on top of earnings. The last thing you want is your savings interest falling into a higher tax band meaning you lose 40% or even 45% of the interest.
That 5% interest rate doesn’t look as good if you only end up receiving 2.75% after tax.
Thankfully, there are plenty of ways to avoid tax on savings interest.
Six Ways To Avoid Paying Tax On Savings Interest
Now because interest rates have gone up and the Personal Allowance has been frozen it doesn’t take holding a lot in cash to start paying tax.
So here are six ways to avoid paying tax on savings interest.
#1 – Check how much you actually need to hold in cash
An easy way to avoid paying tax on savings interest is to hold as little in cash savings as possible.
Whilst it may feel good to finally be earning rates of between 4% and 5% on money in the bank that rate is still low compared to returns that could be made from other assets over the long term.
Yes, it may feel safer holding money in cash rather than investing in other assets like shares, property or gold but you have the opportunity cost and the risk of low returns.
Remember as well, most banks do not hold enough deposits to cover all the savings you have with them. Are banks really that safe?
Yes, I know bank deposits are supposedly protected up to £85,000 but what if we saw another financial crisis like that of 2008. Would the government really come along and bail out all the banks? The UK finances are already in a poor state.
You should only hold enough cash to cover short term liabilities and as an emergency fund that covers 6 months to 2 years regular spending. After this you should be focusing on paying down debt and investing for the long term.
#2 – Use your ISA allowance
You are probably on top of this one anyway but don’t forget to use your ISA allowance each year.
You can add up to £20,000 each tax year into an ISA on top of money you have in an ISA built up from previous years.
Interest earned on cash inside an ISA is tax free.
Make sure your bank offers a Flexible ISA so you can take money out of it and put it back in if you need to.
#3 – Use Premium Bonds
If you have maxed out your ISA allowance and still need to put more cash away consider Premium Bonds.
Premium Bonds are administered by the National Savings and Investments (NSI) which is basically the government bank.
Money held in Premium Bonds is supposedly 100% protected by government.
You can save a maximum of £50,000 into Premium Bonds.
They don’t earn interest as such but instead, all your Premium Bonds are entered into a prize draw each month and you can win anything from £25 to £1million.
The current annual prize fund rate at the time of writing is 4.40% which means you could see your winnings at around this level but depends on how lucky you are.
All winnings are tax free.
#4 – Use Pensions
Whilst the annual ISA allowance is only £20,000 the pension annual allowance is potentially up to £60,000 so plenty more scope.
You don’t have to invest your pension money in the stock market. You could choose to invest it in a money market fund which invests into short term debt offered by other banks and even the UK government which usually has higher interest rates than that offered to bank customers.
You can actually get the proper rates of interest that banks pay to each other.
These types of funds are considered much lower risk in terms of volatility when compared to funds that invest in the stock market.
The only problem with pensions though is that money is locked away until you reach minimum pension age (currently 55 at time of writing). So, if you want access to your cash in the short term this solution may be more suitable to people already over minimum retirement age.
#5 – Use UK government Gilts
In particular Gilts with a short maturity.
A Gilt is essentially a loan to the UK government.
The UK government doesn’t earn enough money through tax to pay all its cost each year, so it borrows to plug the gap.
You can lend your money to the UK government; they will pay you a rate of interest and then return the entire deposit back to you at the end of the agreed term.
You will be offered various rates of interest depending on how long the term is.
The Gilts we are interested in for this scenario is very short term, sometimes a matter of months.
The reason being is that you can sometimes purchase these Gilts on the secondary market at a discount.
For example, at the time of writing you can purchase a Gilt paying 0% interest that will mature at £100 in March 2025 for £92.80.
So, if you invested £9,280 into this Gilt, you would receive back £10,000. That’s a 7.2% return and the best bit, it is tax free. There is no Capital Gains Tax on Gilts.
You just need to be careful on Gilts paying a higher rate of interest as this is subject to Income Tax like normal cash savings.
#6 – Use your partner’s allowances
Finally, we have spoken about your ISA, Pension and Premium Bond allowances but even if you have maximised all you can in these, don’t forget to use your partner’s allowances too.
So, between you it could mean £260,000 could be shielded in these accounts which means you can avoid tax on savings interest.
For married couples and those in civil partnerships there is no Capital Gains Tax on moving assets between each other, meaning you can keep things very flexible.
You could even save into Junior ISAs and pensions for your kids if applicable.
Don’t pay more tax if you don’t need to.
If you would like to stress test your retirement plans or even to get a plan in place then please get in touch for a free no obligation 15-minute call. We would be happy to review your position, explain where you stand and what you need to do to get the outcome you desire. We have created hundreds of happy and protected retirements over the years. This could be you too.
Risk warning:
Stock market linked investments and any income from them, can fall as well as rise and is not guaranteed. Any figures quoted are for illustrative purposes and should not be taken as a forecast or guarantee. Past performance should not be seen as an indication of future returns and clients may get back less than they have invested.
