Cash Isas help savers avoid tax – as rate rises mean just £5,000 could make them liable

Rising interest rates on savings are causing more and more savers to become taxable, according to financial information service Defaqto.

After years of low interest rates, interest rates on savings accounts have now reached their highest level in more than a decade.

The best easy-access savings accounts now offer more than 3 percent interest, which is the highest since September 2012, while term accounts pay more than 4.6 percent.

> View the best low-threshold savings rates here

This is good news for savers, but it also entails possible tax consequences, as it becomes much easier to break the personal allowance.

The personal savings deduction means that UK’s 27.2 million basic rate taxpayers pay no tax on the first £1,000 in interest they earn each year in a regular savings account.

The 5.5 million higher-rate taxpayers have a £500 allowance, while the 629,000 higher-rate taxpayers get nothing.

You can check how much interest you’re likely to earn on your rainy day fund with our long-term savings calculator.

In the past few years, with rates as low as 1 per cent according to Defaqto, savers would have needed a balance of £50,000 or more before breaking the limit, which was no problem for most people.

However, now that savings rates have risen in a short period of time, it’s much easier to earn interest above the tax-free limit.

For example, if someone saves £25,000 in the best one-year fixed deal and pays 4.5 per cent, the interest for the year is £1,125.

This would conflict with the personal allowance and would mean that the person owes tax on the outstanding amount.

For a higher rate taxpayer, saving less than half that amount would mean exceeding the £500 allowance.

There are potentially even more serious tax implications to consider for longer-term fixes.

Fixed-rate savings agreements usually pay interest annually or monthly, or at maturity (when the term expires).

Savers can typically have the interest deposited into another account or have the interest added to the fixed account itself, which will benefit from additional compounding interest.

The problem with the latter approach is that it can become a tax trap. The reason for this is that the interest becomes taxable the moment it becomes accessible.

HMRC states: Interest ‘arises’ when it is received or made available to the recipient. Interest is available if it is credited to an account from which the account holder can freely withdraw.’

If the terms allow the saver to withdraw their money, albeit even with an accrued penalty, the interest is in fact taxable in each year it is credited.

However, if the terms do not allow access until maturity (the end of the full term), the interest cannot be taxed until that time.

This means that someone who receives interest all at once at the end of the term could end up with a much larger tax bill — unless there is a provision to escape the fixed-rate deal.

At worst, £5,000 saved at 4.5 per cent over three years with interest compounded annually will receive £705 at maturity. That’s £205 on top of a higher rate taxpayer’s personal deduction.

> View the best savings deals with a fixed interest here

Income tax thresholds are also frozen until April 2028, so more of those who get a pay rise will be dragged from the 20 percent tax bracket to the higher 40 percent rate.

As a result, their personal savings will be halved to £500 and any interest they earn above this level will be subject to tax.

Michael Conville, Newcastle Building Society’s chief customer officer says: ‘Over the past year, savings rates have risen to such an extent that the level of savings needed to earn interest above the tax-free threshold for personal savings has dropped significantly.

“This means that many savers – especially newer savers and those who built up their savings during the pandemic – need to check whether they are fiscally frugal.

With Cash Isas you can save tax-free

Savers at risk of exceeding their personal savings should max out their £20,000 annual Isa credit.

Additional taxpayers earning £150,000 or more (decreasing to £125,000 or more from next month) will not get a personal savings deduction, so an Isa will certainly make sense under those circumstances.

The best cash Isa rates are currently very close to standard savings accounts, with the added benefit of tax shielding the interest.

The best easy access cash Isa rate is 3.2 percent, which is only slightly less than the best standard easy access account rate of 3.4 percent.

Since there is no tax liability on the interest paid, this may be a better option for those who would otherwise exceed the personal savings limit.

Conville adds: ‘ Before the end of the current tax year on April 5, savers should orient themselves on their own tax position and consider using their tax-free capital.

‘ISAs have been out of fashion for a few years now, but with the recent rise in savings rates, the ISAs can be your best friend if you want to keep your savings tax-free for years to come.’

Setting up a cash Isa account is similar to setting up an old savings account. View the best rates here.

Get the best rate possible

There are no prizes for loyalty when it comes to savings rates and your bank, so anyone looking to get the most out of an Isa should consider switching to get the best interest possible.

> Check out our weekly guide to the best money Isas

Many of the major banks still offer easy access cash Isa rates that pay less than 1 percent.

Savers will also need to figure out whether to keep their money in cheaper, more easily accessible deals or put it in a fixed account for a year or more in exchange for more interest.

If they are using an easily accessible account, they should check if the deal they are signing up for has certain restrictions, such as a cap on the number of withdrawals per year.

“It’s worth looking at mortgage and challenger banks that are currently offering top rates to get the most out of your savings,” says Katie Brain, consumer banking expert at Defaqto.

“In general, you will always get a better rate if you can afford to tie up your money for a period of time.

‘It pays to think carefully about this, because if you have to withdraw your money earlier, you may miss out on interest.

“If you need quicker access to your money, an instant access product might be better, but beware of those accounts that can limit the number of withdrawals you can make per year if you have a lot of withdrawals to make.”