Why Now Might NOT Be the Time to Put Your Savings at 5%

Savers who have money in a savings account with a fixed interest rate will soon have to decide what to do with their savings.

According to Paragon Bank, seven out of ten fixed-interest savings accounts will expire in the next twelve months.

Data from Paragon Bank shows that in most cases these are accounts with a fixed interest rate of one year.

Fixed rate accounts have taken a beating since the Bank of England cut the base rate to 5 percent earlier this month.

On June 1, 25 one-year fixed-rate bonds were offered directly by providers instead of through savings platforms with an interest rate above 5 percent. Now there are only a few left.

But savers can still find accounts that pay this benchmark — or a higher one — if they look closely.

Rather than locking up savings in another account with a fixed rate that will be paid out when the fixed rate expires, more than two million savers with more than £20,000 in their coffers could earn a higher return by moving some of their money into an Isa, even if the interest rate is lower there.

This is because many savers who opt for savings accounts with a high interest rate end up in the savings tax trap, because the Personal Savings Exemption (PSA) has been frozen.

The amount savers pay on the interest on their savings will rise from £6.6 billion in 2023/24 to £10.37 billion in 2024/25, according to official estimates from UK tax authority HMRC.

Of the £10.4 billion the country expects to receive in savings tax, £1.14 billion will come from basic rate taxpayers, £2.4 billion from high rate taxpayers and £6.8 billion from top rate taxpayers.

CACI data shows that in May this year there were 2.3 million fixed rate savings accounts with an interest rate of 2.5 per cent, holding £20,000 or more. This equated to £151.9 billion in savings.

A savings account with £20,000 and an interest rate of 2.5 per cent would earn £500 in interest.

Higher rate taxpayers have their Personal Savings Allowance (PSA) frozen at £500, with any interest earned on this amount subject to 40 per cent income tax.

While fixed rate accounts can offer higher interest rates than cash ISAs, the tax bill savers receive on savings interest means that tax-free ISAs deliver better returns for high-tax taxpayers with large balances.

For example, a one-year fixed rate account paying 5.15 per cent interest and a balance of £20,000 would give a higher rate taxpayer a pre-tax return of £818.

£20,000 in a one-year fixed rate account paying 5.15 per cent will earn £1,030 in interest. As a higher rate taxpayer, the saver will pay £212 of that in tax, giving a net return of £818, according to Paragon Bank.

If that £20,000 was held in an Isa it would give the same return, but at an interest rate of 4.09%.

To achieve the same net return from a cash Isa, the saver would need an equivalent rate of 4.09 per cent. Therefore, any Isa account with a rate above 4.09 per cent would deliver a better return.

Savings interest tax is having a chilling effect on the best savings accounts. It is changing the glittering interest rate on Union Bank of India’s 5.25 best buy one-year fix to 4.2 per cent if you are a basic rate taxpayer and 3.15 per cent if you are a higher rate taxpayer.

Savers can pay up to £20,000 into an ISA in any tax year and any interest they receive on this is completely tax-free.

Millions of savers are using ISAs to protect their savings from tax pressure as interest rates rise.

Savers poured a record £11.7 billion into cash ISAs at the start of this tax year, official data from the Bank of England shows.

This led to cash ISAs receiving their largest inflow at the start of the tax year since tax-free accounts were launched in 1999.

The best way to protect your savings from a tax attack is to put them in an ISA rather than a regular savings account.

Even better is a flexible ISA, which allows you to withdraw your money and, more importantly, pay it back in without affecting your annual allowance – provided you pay it back in the same tax year.

Flexibility is a useful feature of an ISA if you want to keep as much of your savings tax-free as possible.

Savers with larger pots who can max out their £20,000 Isa limit will benefit most from a flexible Isa.