How your higher savings rate might be damaging your tax position
Since the end of 2021 the Bank of England consecutively increased the base rate 14 times with the decision in September 2023 to hold rates, bringing an end to this run. During this run the base rate increased from a paltry 0.10% in 2021 to 5.25% today. As a direct result of the Bank of England’s actions, savings rates have become attractive again, especially given the volatility investors are experiencing with their invested wealth. Many investors are in fact asking whether they should channel more into their savings accounts and away from investments, but this isn’t always that simple. In this article, we look to shed some light on the implications of switching into cash while also providing some tips on ways to help you experience the positive savings rates environment without the negative implications.
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How your savings are taxed and why that is more prevalent than ever?
In the past, for many savers money held in a savings account was fairly tax benign, given the low interest rate environment we experienced for over a decade prior to 2021. Unfortunately, however, from a tax perspective at least, the amounts held in cash are now earning significantly more interest and therefore giving rise to higher tax charges, so what you gain in higher interest rates you lose, in some way, to tax.
All taxpayers in the UK have a Personal Savings Allowance (PSA). The PSA is as follows: a basic rate taxpayer can earn up to £1,000 in savings interest per year without paying tax, a higher rate taxpayer can earn £500 a year without paying tax, while an Additional Rate taxpayer has no PSA therefore pays tax on any interest earned. Due to very low interest rates in previous years, this tax allowance has been all but forgotten about, with the majority of savers accumulating savings interest tax free.
To put this into context, if you had saved in the very best easy access savings account paying 0.50% in July 2021, before interest rates had started to rise, a basic rate taxpayer would not have breached the PSA unless they had over £200,000 saved. Fast forward to today and you’d be looking at breaching your PSA with just £20,000 in a top paying easy access paying 5%. If you’re a higher rate taxpayer, you’d breach your PSA with just £10,000.
The Personal Savings Allowance has remained at its current level since it was introduced in 2016. There are calls for it to be increased during the Autumn Statement in November this year, given the impact it is having on UK taxpayers both at the top end and the bottom end of the tax bandings. It’s joined a long list of “Stealth Taxes” that the Government introduced when it announced plans to freeze allowances and thresholds until 2028. In fact, it’s been reported that the number of people paying tax on their savings income in the 2022/23 tax year has almost doubled to 1.77 million compared to the 0.97 million people in the 2021/22 tax year. The amount collected has more than doubled from £1.2 billion to £3.4 billion and this trend looks set to continue this year as rates have risen further.
While the allowance remains at its current level, it is imperative that you consider and understand the alternative cash options available on the market and the different tax-free wrappers.
What could savers consider?
Fortunately for savers there are a number of things they can do to help mitigate this issue, while retaining the safety offered by cash.
ISAs
First of all, savers could look to Individuals Savings Accounts (ISAs). ISAs are a tax-efficient way to save or invest money. The interest or investment returns within an ISA wrapper are tax-free. There are several types of ISAs, including the more popular Cash ISAs and Stocks and Shares ISAs. ISAs have an annual allowance which is currently £20,000 per annum per individual. The great news is that as well as any interest earned within a Cash ISA being tax free, it does not count towards your Personal Savings Allowance.
There are ISAs available for children, known as Junior ISAs, also ISAs for those saving for a first home or retirement, known as Lifetime ISAs and finally those for people looking to invest into peer-to-peer lending, known as the Innovative Finance ISAs. Rules surrounding these differ slightly. More details can be found here.
Savers can therefore shelter some of their cash holdings from potential tax charges, however, unfortunately there can be a trade-off between using a taxable savings account and the tax-free ISA alternative, which is that the Cash ISA equivalents tend to have lower interest rates. However, recently the gap between the best Cash ISA rates and the equivalent taxable accounts has narrowed, so the return after tax outside an ISA will normally be less – making Cash ISAs very useful once again.
NS&I
An additional savings account available on the market which can provide a tax shelter, while potentially offering a competitive rate of return, is the National Savings & Investments (NS&I) Premium Bonds account. Unlike a standard savings account, you don’t earn interest on your Premium Bonds, instead you are entered into a monthly prize draw where you have the chance of winning anything from £25 to a maximum of £1,000,000 – but the winnings are tax-free! The maximum you can hold is £50,000 per person and the more money you invest the more chances you have to win, but you are not guaranteed to win - you could win nothing month in, month out.
The current interest rate on the prize draw fund is 4.65%, so if you had average luck you could hope to earn this, although you could win nothing at all. If you were to earn the average however, of 4.65%, taking into consideration that any prizes are tax free, a basic rate taxpayer would need to earn 5.8% gross on a taxable account to match the tax-free return from the Premium Bonds, if they are fully utilising their Personal Savings Allowance. For a higher rate taxpayer, it’s 7.75% and an additional rate taxpayer at 45% would need to find a savings account paying 8.45% gross. So, you can see why Premium Bonds continue to be so popular, especially with the wealthy.
These two alternatives offer simple and effective solutions to reduce your tax burden while retaining the positives of holding cash.
SIPPs
There is one other solution worth noting but is dependent on wider circumstances. If you are contributing into a Pension, it’s worth knowing that in modern Self-Invested Pension Plans (SIPPs) you are able to hold cash accounts. This therefore raises a possibility of making a pension contribution, which provides tax relief and tax-free interest, while keeping the money within a cash environment. However, it is worth bearing in mind that the additional complexity of a SIPP comes the need for regular reviews and with that, additional costs. Whilst growth within the pension is tax-free, only 25% of the pension is tax-free on withdrawal, with the remainder taxed at your marginal rate of income tax. Furthermore, you can only access a pension once you have reached 55 (57 from 2028) and it is therefore important to strike a balance between saving for short to medium term objectives, and long-term objectives such as retirement.
Quicks wins with current cash
So, be aware of some additional quick wins which could be beneficial in the short term for your holdings, alongside those mentioned above.
- If your spouse or civil partner is paying a lower rate tax or has no earnings, you could move some of your cash holdings into their name to use their higher PSA and allowances.
- Transfer personal allowances via the marriage allowance.
- Use your £20,000 per annum ISA allowances
- Invest into Premium Bonds up to £50,000
These quick actions could make a noticeable impact on your potential savings related tax bill, while retaining your existing cash on deposit, so still giving you access to the positive interest rate environment while it lasts.
Should you sell your investments and move into cash?
With savings rates so high, it’s easy to see why this question comes up regularly. My colleague Roger Clarke, having been in the industry for more years that he’d like to say, has shed some light on what you could be exposed to by making knee jerk selling decisions within your existing investments and moving into cash article. A key consideration is simply the difficultly and the inherent risks of both timing the sale of assets, particularly in the current volatile markets, and making the conscious decision to re-enter the market. To put this into context between January 1st 2001 and December 31st 2021 the S&P 500 had many ups and downs but, overall, achieved an annualised growth rate of 9.52%. However, if you had missed the best 10 days of growth over that time, the annualised return reduces to just 5.33% which means that the total pot, after twenty years, would be only 45% of the growth compared to the “fully invested” portfolio. This goes to highlight there are dangers of selling existing investments to potentially benefit from the exciting cash rates, and also points to the importance of implementing a robust and coherent financial plan with your adviser. The old saying goes, it’s time in the market, not timing the market.
Be aware what holding too much cash means
Overall, it is essential that you appreciate how you’re managing your cash and not leave it languishing in poor paying accounts. However, in light of the positive interest rate environment, it’s just as important to check how it may be impacting your current tax situation.
If you’d like to learn more about how TPO can help minimise the tax you paid, your savings and investments, why not get in touch and speak to one of our experts.
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Investment returns are not guaranteed, and you may get back less than you originally invested.
This article is intended for general information only, it does not constitute individual advice and should not be used to inform financial decisions.
The Financial Conduct Authority (FCA) does not regulate tax or cash advice.