Will you be hit by a tax bill on your savings as rates rise?

Millions of savers are faced with a tax assessment on their piggy bank for the first time in seven years. Rising rates and increased savings put them at risk of destroying their Personal Savings Allowance (PSA).

Introduced in 2016, this fee makes the first £1,000 of annual savings interest tax-free for basic rate taxpayers. Higher taxpayers get £500. Additional paying parties get nothing.

It’s in addition to any tax-free interest you earn on your money.

With unsuspecting savers now at risk of being stung by hefty tax bills, Money Mail explains what you need to know to avoid getting caught…

Brace yourself for a possible benefit hit

When savings rates were in the doldrums, the PSA seemed generous. At the beginning of last year, the most accessible bill paid only 0.5 percent.

A base rate taxpayer would have needed £200,000 in an account to reach the allowable interest level of £1,000 before tax was due. This meant that most people didn’t have to think about taxing their savings at all.

Even for 40 percent higher payers, the amount you could save before going over the fee was £100,000.

But now easily accessible rates pay as much as 3.25 per cent, following the Bank of England’s key interest rate hike from 3 per cent to 3.5 per cent last month.

In an account that pays 3.25 per cent, you reach your personal savings with £30,770 as the base payer and £15,385 as the higher rate.

Yields on best-buy one-year bonds have risen to a ten-year high of 4.6 percent, while five-year bonds are above 5 percent.

With an interest rate of 5 percent, you use the annual allowance with a pot of £20,000 as the base payer, or £10,000 as a higher rate.

Calculate tax on your savings

Three allowances offer potential tax breaks on your savings interest: the Personal Allowance (£12,570 for this tax year), the £5,000 so-called ‘starter savings’ interest and the PSA.

To determine whether you owe tax, you must first separate your savings interest from your non-savings income. Then view your allowances in a set order – using your personal allowance first.

Let’s say you earn £16,000 from a job or pension and £4,000 from savings. Deduct the Personal Allowance from your income.

You pay nothing on the first £12,570 and 20 per cent on the remaining non-savings income of £3,430 (£16,000 minus £12,570). This equates to a £686 tax bill on your income.

Next, you’ll need to factor in the £5,000 ‘starting rate’ for savings interest. This is aimed at people on low incomes (if your other income is £17,570 or more you are not eligible).

For every €1 of non-savings income on top of your personal allowance, the rate is reduced by €1.

So, in the example above, you deduct the £3,430 you earned above the personal allowance from your £5,000 ‘starting rate’ limit to get a starting rate allowance of £1,570.

This means you can earn £1,570 from savings before tax is due.

So subtract your £1,570 tax-free from the total interest of £4,000 you earned on your savings. That leaves £2,430 (£4,000 minus £1,570) of potential taxable savings income.

Finally, you can apply the Personal Savings Deduction. If you are a taxpayer with a base rate of 20 per cent, you can earn a further £1,000 tax-free with this allowance.

That leaves £1,430 that is taxable. Base rate taxpayers pay 20 per cent tax on this – or £286.

So your total tax bill for the year is £972 (£686 on a pension or salary, plus £286 on savings income).

The amounts are slightly different in Scotland, where tax rates are 19 per cent, 20 per cent, 21 per cent and 41 per cent.

Watch out for the fixed binding trap

You may run into a complication with interest on fixed rate bonds. With a three-year bond, for example, you cannot always use your Personal Savings against the interest every three years.

Instead, you only have one year of compensation in the tax year that the bond matures.

The crucial point as far as HM Revenue & Customs (HMRC) is concerned is whether you can get your hands on your money during the term of the bond.

If you can, you’ll normally pay tax on your interest every year — even if you don’t do anything about it. Here you qualify for the PSA for each of those years.

But if you can’t access your principal or interest during the term, you won’t owe tax on the interest until the bond’s term expires.

You can only apply that year’s PSA to the full three-year interest.

You can’t fool the taxman

If you break your personal allowance, HMRC will know.

Banks, building societies and National Savings & Investments report how much interest they paid you in the tax year up to April.

This information filters through to HMRC during the summer months. It then adjusts your tax code to collect any taxes. Here you can see the amount that you have earned in excess of your allowance.

You do not have to tell HMRC how much interest you have earned unless you complete a self-assessment form.

But you can tell the taxpayer your estimates if you think the code is likely wrong. For example, you had much more savings two years ago than you do now.

Always check your code – it is based on the information HMRC has on you which may be incorrect.

You can correct your details online (gov.uk/personal-tax-account) or call 0300 200 3300.

You can also write to Pay As You Earn And Self Assessment, HM Revenue & Customs, BX9 1AS.

sy.morris@dailymail.co.uk