Rising interest rates could mean you may start to pay tax on interest.
Since 2009, deposit interest rates have been so low that the income generated has been minimal. That fact, combined with the introduction of the personal savings allowance (PSA) in April 2016, means you may well not have had to think about tax on your interest.
As a reminder of the PSA, broadly speaking:
- If you are a basic rate taxpayer (based on English tax bands, regardless of where you live) then £1,000 of interest is free of tax.
- If you are a higher rate taxpayer (again English-based), then £500 of interest is tax free. The difference is a cliff edge – even if you pay only 1p of higher rate tax, your PSA is £500.
- If you are an additional rate taxpayer, then all of your interest is taxable.
Although the PSA has the word allowance in its name, in practice it operates as a 0% tax band on the first £1,000/£500 of interest, which can complicate tax calculations.
In some circumstances, the starting rate band for savings can mean no tax is paid on interest. However, this tax band generally only applies if your total earnings, pension and rental income are below £17,570.
For some years, basic rate tax has not been automatically deducted from most interest payments because to do so would theoretically have meant HMRC having to deal with millions of small income tax reclaims. As rates rise and more interest is paid, however, the number of people who will have to pay tax on some interest is set to increase.
If you think you might be one of those new interest taxpayers, then:
- Check whether you are making the most of independent taxation – your spouse or civil partner may have unused PSA or otherwise pay a lower marginal rate of tax.
- Consider using cash ISAs, which offer tax-free interest. However, the rates on offer can mean ISA returns are less than what you can achieve after paying tax.
- Consider premium bonds as an alternative to quick access deposit accounts if you are a higher rate taxpayer.
- Ask yourself whether the reason you are paying tax on interest is because you have too much on deposit. At a time when inflation is forecast to exceed 13%, your deposits are rapidly losing purchasing power.
Tax treatment varies according to individual circumstances and is subject to change.
The Financial Conduct Authority does not regulate tax advice.