In a recent podcast, Lewis explained that a common misconception about when savings interest becomes taxable is at the heart of this issue. According to him, this misunderstanding could affect people’s tax codes and result in them paying tax on money they haven’t yet accessed.
When Does Interest Become Taxable?
The key to understanding the tax rules on interest is knowing when it becomes taxable. According to Martin Lewis, the moment interest becomes taxable is not when it is paid into your account, but when it is first accessible to you. This becomes particularly significant for those with fixed-term savings accounts.
Many fixed-term accounts pay interest annually but lock away the principal and the interest for a set period, such as two or three years. While interest is added to the account, it is not actually considered taxable until you can access it. In other words, even though the interest may be reported as earned each year, it doesn’t count towards your taxable income until the savings are accessible to withdraw.
This rule may seem subtle, but it is vital for savers to know when their interest is actually taxable. If the savings provider reports interest as being paid, but the interest is locked in until the end of the term, it could lead to tax codes being adjusted incorrectly. This can create an issue, especially if the interest is taxed before the saver can access it.
Retirees at Risk of Overpaying Tax
Martin Lewis has raised concerns that retirees or those nearing retirement may be particularly vulnerable to paying too much tax on their savings interest. For example, many retirees may have a fixed-rate savings account paying interest annually, but the principal and interest cannot be accessed until the account matures after a few years.
If someone was on a higher income tax rate before retirement, but now has a lower taxable income after retirement, they should be taxed at the basic rate (20%) on interest, not the higher rate (40%) they were paying before. However, if the interest is reported to HMRC as being paid during the first year, rather than when it’s accessible, retirees may end up being taxed at the higher rate. This is because the system assumes the interest is taxable immediately, even though it is still locked away and cannot be withdrawn.
Lewis explained that this could lead to a substantial overpayment of tax, especially for pensioners who may not fully understand the tax rules surrounding savings. Many retirees may not realise that their interest is being taxed incorrectly, and with HMRC’s automated system, it’s easy to miss the overpayment until it’s too late.
This issue could also affect savers who do not do self-assessment, as their tax codes may be adjusted automatically based on incorrect reporting. According to Lewis, this is something his team is investigating, as they believe this problem may affect a significant number of people without them even realising it.
