Recent figures from HMRC reveal that nearly 1.4 million people have unintentionally fallen into higher tax brackets, putting them at risk of facing unexpected HMRC tax bills.
These individuals are primarily affected by interest earnings on their savings. For those with over £10,000 in savings, this may lead to an unforeseen tax demand as interest income pushes them into a higher tax threshold.
According to a report from DevonLive, changes to the Personal Savings Allowance and the rising average savings rates have further contributed to this issue. Savers need to be aware of these potential tax liabilities to avoid unwelcome surprises this tax year.
Higher Tax Rates on Interest Earnings
While savers are not directly taxed on the principal amount of their savings, they are liable for tax on the interest earned above certain thresholds. With the Moneyfacts Average Savings Rate currently at 3.53% AER, those with savings of over £14,500 could earn more than £500 in interest this tax year, potentially leading to an unexpected tax bill.
Personal Savings Allowance Changes
For higher-rate taxpayers, the Personal Savings Allowance (PSA) has been halved from £1,000 to £500. As a result, those earning more interest than their new PSA may face an unexpected tax bill. According to Adam French, Consumer Expert at Moneyfactscompare.co.uk, savers need to be aware of their tax liabilities, particularly in light of these changes.
“The latest statistics from HMRC show how important it is for savers to be aware of their tax liability, especially many of those who have fallen into paying the higher-rate tax of 40%,” he stressed.
How to Avoid Unwanted Tax Bills
Despite the potential tax burden, many savers can avoid these charges by utilizing their ISA allowances. Cash ISAs, for example, allow individuals to keep their savings free from tax. Some of the top easy-access cash ISAs even offer interest rates up to 5% AER, providing an opportunity to save without incurring tax penalties.
Tax-Free Allowances Explained
Money-saving expert Martin Lewis clarified these tax rules in a recent BBC podcast, emphasizing that savers pay tax only on the interest earned, not the principal amount. He explained,
“You do not pay tax on your savings. You pay tax on the interest earned on savings. And I know it is a fine difference, but it is an important one.”
“You put money in the bank or building society, and you do not pay any tax on the money you put in, you only pay tax on the money you’ve earned. This is because it is treated like any other form of income, although it does have special allowances, and it’s really important to actually focus on what those special allowances are,” he further clarified,
Lewis highlighted that everyone has a £12,570 tax-free allowance that applies to any form of income, including savings interest. For those in the basic 20% tax bracket, the first £1,000 of interest earned from savings is tax-free. For higher-rate taxpayers, however, this allowance is reduced to £500.
As Lewis explained,
“In savings specifically, if you’re a basic 20% rate taxpayer, you can earn £1,000 a year of interest from any savings source which you don’t pay tax on. That’s £1,000 of interest, not £1,000 in a savings account.”
This means that basic-rate taxpayers can have up to £20,000 in savings at an interest rate of 5%, and still not pay tax, as this would generate exactly £1,000 in interest.
For those in the 40% tax bracket, however, the tax-free interest allowance is cut to just £500. Lewis pointed out,
“As a higher 40% rate taxpayer, you’re allowed £500 of interest tax-free. So it would be £10,000 in there that you would save and you wouldn’t pay interest if you have in the top 5% savings account. If you happen to be a top 45% rate taxpayer earning over £125,000, you don’t get one of these.”
Starting Savings Allowance for Low Earners
Additionally, Lewis discussed the starting savings allowance, which is a little-known tax benefit for low earners. This allowance allows up to £5,000 in interest to be earned tax-free, on top of the £1,000 allowance for basic-rate taxpayers, for individuals with earned income under the standard tax-free allowance of £12,570.
He added,
“For every pound you earn above £12,570, you lose a pound of the £5,000 starting savings allowance.”
For example, if a person earned £13,570, they would only be entitled to £4,000 in tax-free interest.
Lewis elaborated,
“For people where all of their money was generated by savings interest, they would have £12,570, their normal tax-free allowance, they would have their £5,000 starting savings allowance, and they would have their £1,000 savings allowance as a basic-rate taxpayer, meaning you can earn £18,570 tax-free if all your money came from savings interest.”
“And then you could have an ISA on top for £20,000 a year, which would be tax-free, and you could put money into Premium Bonds, £50,000 of which would be tax-free.”
Martin Lewis also addressed the common confusion around ‘double taxation’ on savings. He clarified that savers are not taxed twice on their savings.
“Let’s “be technical, it’s not double taxation. You get taxed on the amount of money you earn on your income, and then you get taxed on the amount of money you earn on your savings. You do not get taxed on your savings.”
