How much savings interest is tax free?

Over the last few years, savers have been rejoicing as the interest they can earn on their hard-earned cash has soared in many cases. That said, it seems that interest rates may have peaked but if you shop around you could still make your cash work harder.  

However, this good news also brings some complexities, namely that many people will now need to pay tax on their savings interest, something they may have avoided when interest rates were at much lower levels. 

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What is the tax-free allowance on savings interest?

There is a tax-free allowance on savings interest that most people will enjoy – namely the Personal Savings Allowance (PSA) but also the cash ISA allowance. And those with other income (so not including the interest on savings) of less than £17,570 a year may also be eligible for the starting rate for savings allowance, which provides up to £5,000 of tax-free interest, in addition to the PSA. 

How much is the Personal Savings Allowance?

The PSA was introduced in April 2016, and it means that basic and higher rate taxpayers can earn some interest tax-free, before paying tax at their usual rate on the remainder. For basic rate taxpayers, the PSA is £1,000 – so the first £1,000 of interest from all taxable cash savings accounts is tax free – and they’ll pay 20% tax on the remainder. Higher rate taxpayers have an allowance of £500. Additional rate taxpayers do not have a PSA at all. This allowance does not include any interest earned in a cash ISA.

As interest rates have increased, savers have been utilising their PSA with smaller and smaller deposits. For example, in December 2021, before the base rate started to rise from its record low level of 0.10%, the top 1-year bond was paying 1.37% AER, so the basic rate taxpayer’s £1,000 PSA would have been used up with a deposit of £72,993. Today however, with the top 1-year bond paying around 4.25%AER at the time of writing, the basic rate PSA would be breached with a deposit of just £23,530. For higher rate taxpayers, just half this amount will breach their PSA which is £500.

This means that as savings rates rise, more people are breaching their PSA threshold with less money saved, making the PSA less effective than it once was. It’s now easier than ever to trigger a tax charge on your savings, even with relatively modest balances. Especially as many allowances, including the PSA, have been frozen until at least 2031. This, along with a freeze on income tax thresholds, is known as ‘stealth tax’, with the impact increasingly being felt each year.

As a result, cash ISAs have become far more popular once again. 

Cash ISA

The Individual Savings Account (ISA) allowance is £20,000 per year – so savers can shelter £20,000 into an ISA each year. There are four main types of adult ISA, stocks and shares ISA, cash ISA, Lifetime ISA (LISA) and the Innovative Finance ISA. There is also a child’s ISA – called the Junior ISA or JISA. The LISA is a special type of ISA for 1st time buyers or for those saving for retirement. The annual allowance for this is £4,000, but this forms part of the overall £20,000 ISA allowance. 

Learn more about the different types of ISA

For those who’d rather use their ISA allowance to earn tax free savings interest, the cash ISA is a great option. The interest earned within a cash ISA is always tax-free, regardless of the amount.

From April 2027, the annual ISA subscription limit for cash ISAs will be reduced from £20,000 to £12,000 for savers under the age of 65. This marks a significant change and means many working-age savers will have less of a tax-free shelter for their savings. Those aged 65 and over will retain the £20,000 limit. 

Starting rate for savers

This applies to fewer people, but if your ‘other’ income – so salary, or pension income for example – is less than £17,570 a year, you could be eligible for tax free interest of up to £5,000 in addition to your PSA. The more you earn above your Personal Allowance (not to be confused with your PSA) which is currently £12,570, the less the starting rate is; every £1 of other income above your Personal Allowance reduces your starting rate allowance by £1.

It can be pretty complicated, so here’s an example to help illustrate the point: Sarah earns £13,000 in pension income plus she has £6,200 in savings interest. Although her total income is £19,200, because her ‘other’ income is £13,000, she is eligible for at least some of the starting rate for savings.

However, as her pension income is £430 more than the Personal Allowance, her starting rate allowance is reduced by this amount so will be £4,570 (£5,000 minus £430).

So, she has a starting rate allowance of £4,570, plus her PSA of £1,000, as she is a basic rate taxpayer, a total of £5,570. As her savings interest is £6,200, this is still a little more than her allowances, so she should have to pay 20% tax, but only on £630.

Of course, this is for illustrative purposes only, to indicate how these allowances work together. We are not authorised to give tax advice, so you should seek advice from a tax expert. 

How much tax will I pay on savings interest?

Although the PSA is being utilised with smaller deposits, because you can also deposit £20,000 into a cash ISA (falling to £12,000 a year from April 2027, for those aged under 65) if you have not used your ISA allowance elsewhere, you can boost the tax-free interest you can earn.

For example, if you are a basic rate taxpayer with £50,000 in cash (and ‘other’ income of more than £17,570 – so you’re not eligible for the starting rate for savers) and you were considering a 1-year fixed rate bond, if you were to deposit this money into a standard taxable account earning the current top rate of around 4.25% AER, you would earn £2,125. As you have a PSA of £1,000 you would need to pay 20% tax on £1,125, which is £225. So, you would take home £1,900 after tax.

However, if you were to put £20,000 into a top paying 1-year cash ISA paying around 4.15% and the remaining £30,000 into the bond, you will pay less tax and take home more, even though the ISA rate appears lower than the bond. 
£20,000 in the ISA at 4.15% would earn £830 tax-free.

£30,000 in the bond at 4.25% would earn £1,275 before tax but you’d need to pay 20% on £275 – which means deducting £55.

So, in the second example, you’d earn £2,050 after tax – £150 more!

For the most up to date interest rates available, take a look at our savings rates best buy tables.  

What happens if I exceed my Personal Savings Allowance?

When the PSA was introduced, the biggest change to our savings was the way that interest was paid. Before the PSA, interest was paid after the deduction of basic rate tax, unless you were a non-taxpayer and completed an HMRC form to confirm this. However, from April 2016 this changed and all interest is now paid without any tax deducted.

For the majority of those who are part of the PAYE scheme, so anyone with employed income or pension income, HMRC will take an estimate of tax due on your savings and amend your tax code accordingly. But this will be based on old information supplied by the banks and building societies, the actual interest you earn over the coming year may be very different, especially if you have added or removed large amounts of cash since the last tax year.

So, it’s important to review your tax code letter which shows the interest HMRC has assumed you will earn and inform HMRC if things don’t look right. 

If you already do a self-assessment tax return, you can pay any tax due via that process.

How can we help?

Whilst earning interest on your savings should be simple, there are clearly a number of things to consider – but ultimately it makes sense to earn as much as you can and the recent increases in interest rates means that there is a great opportunity to earn some meaningful interest on your cash savings once again. 

If you want to find out how you can earn more on your hard-earned cash, why not get in touch. We’re offering everyone with £100,000 or more in savings, investments or pensions a free financial review worth up to £500.

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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 advice.