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With the Bank of England (BoE) steadily raising the base rate, savers are seeing some benefits in the form of higher interest rates on their regular savings accounts and Cash ISAs. However, this could also lead some savers to pay tax on their interest, which perhaps they didn’t pay before. Below, our team at Elmfield Financial Planning in Padiham explains how this new “savings rate trap” works and suggest ways to navigate it with your own savings plan. We hope this content is useful and please get in touch if you’d like to discuss your own financial plan with us over a free, no-commitment consultation.
Why are savings more at risk of tax?
Each tax year, every Basic Rate taxpayer is entitled to earn up to £1,000 in interest without tax via their Personal Savings Allowance. For a Higher Rate taxpayer, you can earn up to £500 in interest without tax. You do not need to put cash into an ISA to benefit from this allowance; you can simply keep it in your regular account(s).
For the 2021-22 tax year, the low interest rates widely offered by lenders on savings accounts meant that savers could hold large sums of cash, outside an ISA, without needing to worry about tax on the interest. For a Basic Rate taxpayer with a 1.86% easy-access (non-ISA) account, for instance, this meant that up to £53,750 could be saved without facing tax on the interest earned. For a Higher Rate taxpayer on the same account, the figure was £26,900.
Now in October 2022, however, interest rates on regular accounts are rising due to the BoE increasing the base rate (to try and combat rising UK inflation). The base rate currently sits at 2.25%; raised by 0.75% on Thursday 22nd September, and likely to rise even more in the coming months. Now, it is possible to find easy-access variable accounts with 2.1% interest rates, which could lead a Higher Rate taxpayer to start paying tax on interest from savings over £23,800 (i.e. £3,100 less than the 1.86% account above). If the BoE continues to raise interest rates to 3.75% by the end of 2022 (as widely expected), the tax-free threshold for this Higher Rate taxpayer could fall to £13,338. If it goes to 4.5%, then it could go down to £11,100.
How can I protect my cash savings from tax?
In recent years, it has typically not been worthwhile using your ISA allowance to save cash. In 2022-23, you can save up to £20,000 across your ISAs and earn interest, dividends and capital gains without these getting taxed. Since interest on your cash savings may not have been taxed anyway (due to any earned interest falling below the £1,000 / £500 tax-free threshold), you could have simply saved the cash in regular accounts and use the ISA allowance to build non-cash investments with a better opportunity for producing returns (such as equities). Now, however, moving cash savings into a cash ISA is likely to become a more popular move to protect their interest from tax due to the rising base rate.
Some important considerations need to be borne in mind, however, before rushing your cash savings into an ISA (potentially using up your allowance for the year). Firstly, make sure that you shop around for the best ISA deal. The tax saving from moving cash to an ISA may not translate to a higher overall return if the Cash ISA offers a poor interest rate. Secondly, make sure you do not incur an unnecessary “opportunity cost” when putting cash into an ISA. By focusing your ISA allowance mostly on shares, for instance, you may save more in capital gains tax (CGT) in the future than if you committed your ISA allowance mostly to cash. With this said, if you do not plan to make full use of your ISA allowance before the April 2023 deadline, then it might be worth moving more cash into your ISA(s) to protect against possible tax on your interest.
Finally, be careful with fixed-rate accounts in the coming months. These tend to offer higher interest rates than variable deals, but lock your money away (e.g. for 2 years). Putting too much into these accounts could lead to a tax liability later if interest rates continue to rise into 2023. It might also mean that you miss out on better fixed-rate deals next year, when the base rate could rise further (leading high street banks to raise their own interest rates). You can, of course, often take your money out of a fixed-rate account early. Yet there is typically a penalty involved which eats away at your total returns (e.g. 90 days’ worth of interest).
Invitation
If you are interested in starting a conversation about your own financial plan or investments, then we’d love to hear from you. Please contact us to arrange a free, no-commitment consultation with a member of our team here at Elmfield Financial Planning in Padiham, Burnley, Lancashire.
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