Sneaky Tax Traps on Savings Interest | The Tax Loopholes You Need to Know

More than two million people in the UK will face a tax bill on their savings interest this year due to rising interest rates and frozen tax thresholds. Many may be unaware of their tax liability until they receive a letter from HMRC.

A Freedom of Information request from AJ Bell revealed that 2.07 million people will pay tax on their savings in the 2023/24 tax year, compared to just 650,000 three years ago.

This increase includes almost one million basic-rate taxpayers, highlighting how widespread the issue has become.

While it may be too late to change your tax position for the current year, there are ways to restructure your savings to reduce the tax burden in the future. Understanding how savings interest is taxed and knowing the available tax-efficient options can help you avoid unexpected tax bills.

What Is the Personal Savings Allowance and How Does It Affect You?

The Personal Savings Allowance (PSA) was introduced in 2016 to allow individuals to earn a certain amount of interest on their savings tax-free. The allowance depends on your income tax band:

• Basic-rate taxpayers (20%) – Can earn up to £1,000 in interest per year tax-free.
• Higher-rate taxpayers (40%) – Have a lower limit of £500 before tax applies.
• Additional-rate taxpayers (45%) – Do not receive a PSA and must pay tax on all savings interest.

Many savers unknowingly exceed their PSA, especially as interest rates rise.

For example, with a 5% interest rate, a basic-rate taxpayer would only need £20,000 in a savings account to breach their PSA, while a higher-rate taxpayer would exceed their limit with just £10,000 saved.

If you exceed your PSA:

• PAYE taxpayers – HMRC automatically adjusts your tax code based on data from banks and building societies. This tax is deducted from your salary each month.
• Self-Assessment taxpayers – You must declare your savings interest and pay any tax owed when filing your return.

Understanding your PSA and structuring your savings accordingly can help minimise unexpected tax bills.

How Can ISAs Help You Avoid Tax on Savings Interest?

Individual Savings Accounts (ISAs) provide a tax-efficient way to save, as all interest earned within an ISA is free from income tax. There are different types of ISAs available:

• Cash ISAs – Work like a standard savings account but with tax-free interest.
• Stocks and Shares ISAs – Invests money in shares, bonds, and funds with potential for higher returns.
• Lifetime ISAs – Designed for first-time homebuyers and retirement savings, with a government bonus.
• Innovative Finance ISAs – Focus on peer-to-peer lending and alternative investments.

The annual ISA allowance is currently £20,000, meaning you can transfer up to this amount each tax year without paying tax on interest.

If you have a partner, you can collectively shelter £40,000 from tax by using both allowances.

Many savers ignored ISAs in recent years because interest rates were low, and the PSA seemed sufficient. However, with rising rates, more people are exceeding their PSA, making ISAs a valuable tool for avoiding tax on savings.

Key considerations when using ISAs:

• Plan ahead – If you hold significant savings outside an ISA, gradually move funds into an ISA each tax year to avoid breaching the allowance.
• Maximise your allowance – If you haven’t used your ISA allowance for the current tax year, consider moving savings into an ISA before the April deadline.
• Use both partners’ ISAs – Splitting savings between spouses or partners can effectively double the tax-free limit.

Why Do Fixed-Rate Savings Accounts Pose a Tax Risk?

Fixed-rate savings accounts offer guaranteed interest rates over a set period, making them attractive to savers looking for stability. However, they come with a hidden tax risk.

Interest from fixed-term savings accounts is taxed when it becomes accessible, meaning if an account pays interest at maturity rather than annually, several years’ worth of interest could be taxed in one go.

This could push you over your PSA and create an unexpected tax liability.

Example scenario:

• A three-year fixed savings account with £7,000 at 4.63% interest would generate £1,018 in interest upon maturity.
• A basic-rate taxpayer with a £1,000 PSA would be taxed on the extra £18.
• A higher-rate taxpayer with a £500 PSA would be taxed on £518.

To avoid this tax trap:

• Choose accounts that pay interest annually or monthly rather than at maturity.
• Consider a fixed-term ISA, which allows tax-free interest accumulation.
• Check the maturity date of your savings products to ensure they don’t cause a sudden spike in taxable income.

Fixed-rate accounts can still be beneficial, but planning when and how interest is paid can help you stay within your PSA.

Can Your Child’s Savings Impact Your Tax Bill?

Many parents save money in their child’s name, but there is a hidden tax rule that could result in an unexpected tax bill.

If a child earns more than £100 per year in interest from money gifted by a parent, the interest is taxed as the parent’s income. This means:

• If the parent has already exceeded their PSA, they will have to pay tax on the child’s savings interest.
• This rule applies per parent, so splitting savings between both parents can help keep interest below the taxable limit.
• Grandparents and relatives are not affected by this rule, so gifts from them do not count towards the parent’s tax liability.

Example scenario:

• A child has £2,000 in a top-paying savings account at 5% interest.
• This earns £100 per year, which is within the tax-free limit.
• If the child’s savings grow to £3,000, generating £150 in annual interest, the full £150 is taxed as the parent’s income, not just the excess.

To avoid this:

• Use a Junior ISA, which allows tax-free savings up to £9,000 per year.
• Ensure that gifts from each parent do not generate more than £100 in interest annually.
• Consider asking grandparents or other relatives to contribute to the child’s savings instead.

Do Joint Savings Accounts Create Unexpected Tax Bills?

Joint savings accounts allow couples to combine their savings, but they can create unexpected tax bills. The interest earned is split equally between both account holders.

For example, if a joint account generates £1,000 in interest:

• A basic-rate taxpayer with a £1,000 PSA would remain within their allowance.
• A higher-rate taxpayer with a £500 PSA could be taxed on their £500 share of the interest.

To manage this tax risk:

• If one partner has a lower tax rate, consider holding savings in their name to use their PSA more effectively.
• If both partners have the same tax rate, ensure that each person’s PSA is fully used before exceeding limits.
• Consider ISAs or NS&I products to avoid taxable interest altogether.

What Other Tax-Efficient Savings Options Should You Consider?

Beyond ISAs, there are other ways to reduce tax on your savings:

• National Savings & Investments (NS&I) – Some NS&I products, such as Premium Bonds and certain savings certificates, offer tax-free returns.
• Premium Bonds – Instead of interest, winnings from the monthly prize draw are tax-free.
• High-interest current accounts – Some banks offer competitive interest rates within PSA limits.
• Government Bonds and Gilts – Certain government-backed savings products have tax advantages.

Diversifying your savings into tax-efficient accounts can help reduce or eliminate tax liabilities on interest earned.

How Can You Plan Ahead to Minimise Tax on Savings Next Year?

With interest rates rising and tax thresholds remaining frozen, it is crucial to plan your savings strategy in advance to minimise tax liabilities and maximise returns.

Many savers unknowingly exceed their Personal Savings Allowance (PSA) and only realise it when they receive a tax bill or a reduced take-home salary due to HMRC’s tax code adjustments.

By taking proactive steps now, you can reduce or eliminate tax on savings interest in the coming tax year.

1. Review Your Savings and Interest Income

The first step in tax planning is understanding how much interest your savings are generating and whether it could push you over your PSA limit. Conduct a thorough review of:

• The total amount of savings you hold across all accounts.
• The interest rates on each account and whether they are expected to increase.
• The timing of interest payments, especially for fixed-term savings accounts, which might generate large payouts in a single year.
• Any changes to your tax band—moving from a basic-rate taxpayer (20%) to a higher-rate taxpayer (40%) will cut your PSA from £1,000 to £500.

By understanding your expected interest income, you can make informed decisions about where to allocate your savings to stay within your tax-free limits.

2. Move Savings Into an ISA Before the Tax Year Ends

Individual Savings Accounts (ISAs) offer a straightforward way to shield savings from tax. Interest earned within an ISA is completely tax-free, making them one of the best tools for tax planning.

• The annual ISA allowance is £20,000, so transferring taxable savings into an ISA can prevent you from breaching your PSA.
• If you have a partner, consider using both of your ISA allowances, effectively sheltering £40,000 per year from taxation.
• If you haven’t used your ISA allowance yet, act before April 5th, as unused allowances do not roll over to the next tax year.

If you have already maxed out your ISA, consider switching to other tax-efficient savings options, such as NS&I Premium Bonds or government-backed bonds.

3. Spread Savings Across Different Accounts to Control Interest Timing

For those holding fixed-rate savings accounts, interest may be paid at maturity rather than annually.

This means that if you have a three-year fixed savings account, all the accumulated interest could be taxed in a single year, potentially pushing you into a higher tax bracket.

To avoid this:

• Opt for accounts that pay interest monthly or annually, rather than at maturity, to spread out your taxable income.
• Stagger your fixed-term savings so that interest payments do not all fall into one tax year.
• Use tax-free fixed-term ISAs, which provide the same fixed-rate benefit without the tax burden.

By distributing interest income across multiple years, you can ensure that you remain within your PSA each tax year.

4. Consider Transferring Savings to a Lower-Tax Partner

If you are in a higher tax bracket but your spouse or partner earns less, it may be tax-efficient to move some of the savings into their name.

This allows you to make better use of their Personal Savings Allowance and reduce overall tax liability.

For example:

• A higher-rate taxpayer (40%) has a PSA of only £500, while a basic-rate taxpayer (20%) has a PSA of £1,000.
• If the higher-rate taxpayer earns £1,200 in savings interest, £700 is taxable, whereas if the lower-taxed partner holds the savings, only £200 would be taxable (or none, if within their PSA).

However, before transferring money, consider:

• The implications of ownership—once transferred, the money belongs to your partner.
• How it might affect your partner’s tax situation, including any impact on benefits or allowances.

5. Use National Savings & Investments (NS&I) for Tax-Free Alternatives

National Savings & Investments (NS&I) offer government-backed savings products that can provide tax-free interest or winnings, including:

• Premium Bonds – Instead of earning interest, savers participate in a prize draw. Any winnings are completely tax-free and do not count towards your PSA.
• NS&I Direct Saver and Income Bonds – While these accounts are taxable, they offer secure savings options backed by the government.
• NS&I Index-Linked Certificates (if available) – These protect against inflation and offer tax-free returns.

By allocating part of your savings into NS&I products, you can reduce taxable interest income while still earning returns.

Conclusion

More UK savers than ever are facing tax on their savings interest due to rising rates and frozen tax thresholds.

While it may be too late to change the outcome for the current tax year, there are steps you can take to avoid unnecessary tax bills in the future.

Utilising ISAs, understanding how fixed-rate interest is taxed, and considering alternative tax-efficient savings options can help protect your savings from taxation.

Reviewing your finances and taking action before the next tax year can ensure you maximise your savings without unexpected deductions.

FAQs 

How Do I Check If I Owe Tax on My Savings Interest?

Banks and building societies report interest payments to HMRC. You can check your tax liability by reviewing your savings statements and tax code adjustments.

What Happens If I Exceed My Personal Savings Allowance?

Any interest earned beyond your PSA is subject to tax. For PAYE taxpayers, HMRC adjusts tax codes. Self-Assessment filers must report and pay tax directly.

Are There Any Tax-Free Savings Options Besides ISAs?

Yes, National Savings & Investments (NS&I) products, Premium Bonds, and some government bonds offer tax-free interest or prizes.

How Does HMRC Track My Savings Interest?

Banks and financial institutions automatically report interest payments to HMRC, which then assesses tax liability.

Can I Avoid Savings Tax by Transferring Money to Family Members?

Transferring savings to a lower-earning spouse can reduce tax, but gifting money to children may trigger parental taxation rules.

How Often Does the Government Review Personal Savings Allowance Limits?

The PSA has remained unchanged since 2016. Changes depend on government policy and economic conditions.

Do I Need to Report Savings Interest If Tax Is Deducted Automatically?

If tax is deducted via PAYE adjustments, no further action is required. However, if you file a Self-Assessment tax return, you must declare all taxable interest.