How to be tax-efficient with your savings

How much interest can you earn on savings without paying tax?

The point at which you start paying tax on savings depends on how much you earn. Most people benefit from what’s known as the Personal Savings Allowance (PSA). The PSA lets you earn interest on your savings without paying taxes up to a certain point. How much you can earn tax-free depends on your income:

• Basic rate taxpayers can pocket £1,000 per year in savings interest without worrying about taxes

• Higher-rate taxpayers have a lower threshold and can only earn £500 per year in savings interest before paying tax

• Additional-rate taxpayers don’t have a personal savings allowance.

If you don’t earn enough to pay income tax, you get a starting rate for savings worth £5,000, meaning you have a £6,000 tax-free savings allowance. You can also earn anything up to the income tax threshold of £12,570 tax-free. This means your total tax-free earnings from savings interest could be as much as £18,750.

How much can I save before I pay tax?

It depends on how much interest your account earns. If you’re a basic-rate taxpayer with an account paying 5%, you could save £20,000 before reaching the £1,000 limit for tax-free savings. If you’re a higher-rate taxpayer, you could save £10k at the same interest rate before paying tax. On the other hand, if you’re an additional-rate taxpayer, you would pay tax on any interest earned as you have no PSA.

It's important to understand that you only pay tax on the interest you earn, not the savings themselves. If you have significant sums of money to save, you should explore tax-free options.

How do you avoid paying tax on savings interest?

If you’re at risk of paying tax on your savings, there are several steps you can take to reduce your tax burden. Banks and building societies typically offer better savings rates than ISA accounts, so you should save as much as possible with them before you hit your personal savings allowance. 

Once you hit that threshold, there are plenty of tax-efficient ways to save.

ISAs

Individual Savings Accounts (more commonly known as ISAs) allow you to save and invest tax-free. Everybody has an ISA allowance each year worth £20,000, which you can use to invest in one or more types of ISA.

The main ones are:

• Cash ISAs. These work like ordinary savings accounts, but any interest is tax-free. You may get better rates by fixing for a set period

• Stocks and shares ISAs. These allow you to invest your money without paying tax on the returns

• Innovative Finance ISAs. These are for peer-to-peer lending

• Lifetime ISAs. These give you a 25% government bonus on everything you save, up to a maximum bonus of £1,000 per year. You must use the money to buy a first home or for retirement

Pensions

Money invested into your pension is tax-free. When you save money for retirement, the government gives you tax relief, which is added to what you save. This is a valuable benefit that helps your money to grow much faster. However, remember that you won’t be able to withdraw money held in a pension until you are 55 (moving to 57 from April 2028). That means you should only use a pension to save money for your long-term future.

However, the tax relief on offer is limited. The government will only give you tax relief on private pension contributions up to the value of your total annual earnings, up to a maximum of £60,000 (the current annual allowance). In effect, no one can save more than £60,000 a year into a pension tax-free. This allowance is reduced for ultra-high earners who have a ‘threshold’ income of more than £200,000 and an ‘adjusted’ income over £260,000. Visit Gov.uk for more on these.

Once you hit retirement, the money you withdraw from your pension is taxed as income, just like pre-retirement earnings. However, 25% of your total pension pot is tax-free. You can either take this up front as a lump sum or spread the tax-free benefits across every withdrawal you make. Apart from your tax-free lump sum, you should be careful to only take out what you need each year. This way, you can avoid paying extra taxes unnecessarily.

Premium Bonds

Premium bond wins are also tax-free. NS&I calculates that the annual prize fund rate is currently 4.15%, but some people will win considerably more, while others will win less or nothing. It can be a fun way to save, but it probably isn’t the best use of your cash unless you have already maxed out your annual ISA and pension saving allowances.

Savings for children

If you want to save for your children, there are plenty of tax-efficient ways to do so.

Junior ISAs

Family and friends can put up to £9,000 into a child ISA. No tax is due, and the money belongs to the child. The child can access it once they reach 18 but may be able to manage it from 16.

Child trust funds (CTFs)

These are now closed to new applicants, but you may still have one if your child was born between 1 September 2002 and 2 January 2011.

Children’s pensions

You can save up to £2,880 into a pension for your child, and the government will top it up with an extra £720 in tax relief. The child won’t be able to access the money until they are 57.

How to pay any tax you owe on savings interest

If you usually complete a self-assessment form to pay your tax bill each year, you will need to declare any savings as part of your return. HMRC will calculate how much you owe and include it in your annual payment.

If you’re employed or already receive a pension, HMRC will usually reclaim what you owe through your tax code. However, if you’re earning over £10,000 a year in savings interest, you will need to declare it using a self-assessment form.

Where to get tax advice

If you want more help to arrange your financial affairs in a tax-efficient manner, you can use an independent financial adviser. You can find one through the unbiased.co.uk website.