Savers who prefer bonds with a longer term can avoid the tax trap of the Personal Savings Allowance by 'paying away'

More savers will have to pay taxes on their interest as savings rates rise – but the good news is that a technique called 'paying away' can help reduce these bills.

By 2023, 37 percent of savers will earn enough interest on their savings to exceed their personal savings allowance (PSA), according to research from Paragon Bank.

The annual PSA is £500 for higher rate taxpayers and £1,000 for standard rate taxpayers, while for extra rate pax taxpayers it is £0.

The PSA has largely remained under the radar in recent years because savings interest rates were so low that almost no savers exceeded their benefit.

But rising savings rates have brought the issue of interest tax back into the spotlight.

Two ways savers can avoid the PSA are by taking out an Isa or putting their money into NS&I Premium Bonds, as the interest earned on both is not taxed.

But if savers prefer bonds with a longer term and a fixed interest rate, 'paying off' the interest could mean that money on the interest earned does not have to be handed over to the tax authorities.

When paying away, the saver chooses to have the interest on longer-term bonds deposited annually into a designated account.

This technique helps avoid tax on savings interest because, according to the PSA, you pay tax annually on the interest you earn that year.

For example, a higher rate taxpayer with £10,000 in a five-year fixed rate bond paying 4 per cent would normally earn £2,209.97 in interest.

On the basis that the interest earned is £1,709.97 above the £500 PSA, they would have to pay 40 per cent of that amount in tax, which amounts to £683.09.

A higher rate taxpayer would now need to have a balance of just £10,000 in a non-ISA account and pay 5 per cent interest to breach their PSA.

But if they chose to pay the interest into a designated account, the saver would earn the same total amount, but split into five parts of around £407 per year.

That is below the level of the £500 PSA, meaning the saver owes nothing to the tax authorities, according to Paragon Bank research.

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Andrew Hagger, founder of personal finance website MoneyComms, says: 'If a saver took out a three-year 5 per cent bond with a balance of £10,000, they would earn £500 interest per year if paid off annually.

'The problem comes when they take all the interest as a lump sum at the end of the term, when they would have to pay £1,500 interest for three years, and £2,500 interest for five years.

'For example, if interest rates were 2 percent, this would be less of an issue, because you would need £50,000 to earn £1,000 interest in a year, or £25,000 to earn £500 in a year – but higher interest rates mean that much more people with smaller savings balances could now exceed their PSA.”

If you have a longer term fixed rate account, some providers allow you to change the way you receive interest over the medium term.

Paying it off means less interest in total

Savers who choose to pay off should be aware of the loss of compound interest that comes with taking interest by letting it pay off.

As the interest payment accumulates each year in the fixed interest account, the saver receives interest on the interest payment, as well as on the opening balance.

For a higher rate taxpayer with £10,000 on a five-year fixed rate account paying 4 per cent, that makes a difference of £172.97 in the total interest earned on the £10,000 balance.

This saver is better off choosing this option, because the amount of tax is considerably higher.

One option for savers who choose to pay away is to place the interest payment into a separate savings account with a comparable interest rate, which should make up for the shortfall.

Another way to alleviate this problem is to use a fixed rate Isa for part of your savings pot, as this is completely tax free.

Paragon found that more than half of savers have chosen to transfer non-Isa savings to Isas, while 40 percent have opened new cash Isas.

Derek Sprawling, savings director at Paragon Bank, said: 'With three in ten savers now paying tax on their savings interest, it is vital to adopt tax-efficient strategies, such as using Isas, to protect your hard-earned savings and to consider receiving interest. “paid off” on longer-term bonds.”