How does savings interest and tax work?

Here is how interest works on your savings and how tax can affect what you get as a return.

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What is savings interest?

It is money you earn in return for holding your savings in an account. The amount of interest you earn is set by the rate offered by your savings account.

For example, if you have £1,000 in a 1 year fixed bond paying at rate of 2%, the savings interest you earn will be £20 over the year (2% of £1,000 = £20).

There are many things that affect the amount of interest your savings account will pay, such as:

  • The level of access

  • How often interest is paid out

  • How much you can pay in

  • Competition in the marketplace

  • If it is taxable

Read this guide to find out how savings accounts work

What types of interest are there?

  • Compound interest: This is when you earn interest on the interest you have already received from your savings. You lose this if your interest is paid into another account.

  • Annual interest: This is when your interest is paid once a year; either on a set date or on the maturity date of the account.

  • Monthly interest: This is when you have your interest paid on a monthly basis. This method may work well if you want to receive your savings interest as a regular source of income.

This table shows the difference between the interest you would earn on £5,000 over 5 years if you chose to compound interest or have your interest paid to another account:

Updated 8 April 2020
TimescaleCompound interest paid annuallyInterest paid out annuallyInterest difference
After 1 year£150£150£0
After 2 years£154.50£150£4.50
After 3 years£159.14£150£9.14
After 4 years£163.19£150£13.91
After 5 years£186.83£150£18.83
Total interest paid£796.37£750£46.37

Based on the table above, if you had your interest paid monthly you would have £12.50 paid to you each month.

When you get paid your interest monthly, your annual interest will be the same each year as long as the interest rate remains the same.

Do you pay tax on savings?

Yes, but you do not need to pay tax on all of the interest you make on your savings if you qualify for a starting rate for savings, personal savings allowance or personal allowance.

What is the starting rate for savings?

If you earn under £17,500 in other (non-interest) income, you will qualify for a starting rate for savings. This provides an initial buffer before you begin to eat into your personal savings allowance. It is currently set at £5000 for the 2020/21 tax year.

For every £1 you earn from other income over the personal allowance of £12,500, your starting rate for savings decreases by £1.

That means that if you earn £12,500 from other income, your savings income will not eat into your personal savings allowance unless it exceeds £5,000.

If you earn £15,000 per year from other income, your starting rate for savings will be £2,500.

What is the personal savings allowance?

It is an allowance that lets you earn a set amount of interest from your savings without paying any tax.

  • Basic rate taxpayers can earn £1,000 worth of interest before paying tax on their savings

  • Higher rate taxpayers can earn £500 worth of interest before paying tax on their savings

  • Additional rate taxpayers will not have a personal savings allowance

The personal savings allowance is in addition to any other allowance that you may be entitled to.

What is the personal allowance?

It lets you earn a set amount of money each tax year before you have to pay tax on your earnings, including your savings interest.

In the 2020/21 tax year, you have a personal allowance that lets you earn up to £12,500 without paying any tax.

This means that you will only pay tax on savings interest if it exceeds your starting rate for savings and personal savings allowance and your total income exceeds your personal allowance.

This table shows you how much tax you pay on your taxable interest:

Updated 16 April 2020
TaxpayerTax deduction
Basic rate20%
Higher rate40%
Additional rate45%

Alternatively, you can earn interest tax free by using your ISA allowance each tax year. Here is everything you need to know about saving with an ISA.

How else can you save on savings tax?

You can also pay less tax if you qualify for one of the following:

Marriage Allowance

This lets you transfer up to £1,250 of your personal allowance to your husband, wife or civil partner.

The transferring partner must have an annual income of £12,500 or less and the receiving partner must be a basic rate taxpayer.

Married Couple's Allowance

This could reduce your tax bill by between £336 and £869.50 a year if either you or your partner was born before 6th April 1935.

Visit the GOV.UK. website to find out if you qualify for the Married Couple's Allowance.

Blind Persons Allowance

This is a £2,500 tax free allowance on top of your personal allowance.

You can transfer this allowance to your spouse or civil partner if you do not earn enough of an income to benefit from the full allowance.

To qualify for the Blind Person's Allowance, you need to be registered with your local council as blind or severely sight impaired.

Can you claim tax back?

If you have already paid tax on your savings this tax year you can ask your provider to refund after registering your R85 with them.

If you had paid tax in previous tax years you will need to complete an R40 form. This form allows HMRC to find out if you have overpaid tax and if you are owed a refund.

Maximise the value of your savings by hunting down the best rates available.