Five sneaky ways you could be hit with tax on your savings

Cash interest rates have risen, more people are being pushed into the next tax bracket and millions of people are expected to pay tax on their savings income this year. While lots of people are using ISAs to protect their money from tax or organising their savings to cut their tax bill, there are some sneaky tax traps that will catch some savers out without even realising it.

The Personal Savings Allowance protects lots of people from paying tax on their savings. The tax-free allowance means that basic-rate taxpayers can earn £1,000 in savings income before they pay tax on it, while higher-rate taxpayers have a £500 allowance. Additional-rate taxpayers have no allowance. But lots of people will breach this limit this year – maybe without knowing.

The sneaky traps that mean you'll pay tax on savings

Trap 1: Fixed-rate accounts

Lots of people are picking fixed-rate savings accounts at the moment, locking their money up for one, two, three or even five years to get a guaranteed interest rate. However, many people won’t realise that this could leave them with a tax headache in the future. You are taxed on the interest on your savings when it is accessible by you. So if you pick a fixed-rate savings account that pays out all the interest at maturity, for tax purposes all of that interest will be counted in one tax year. This means that the interest from just one account could take you over your Personal Savings Allowance on its own.

It’s particularly a problem for longer-term fixed accounts, as you would have three or even five years of interest paid out in one go. For example, £7,500 in savings in the current top three-year fixed-rate account paying 4.51%* would pay out £1,061 interest at maturity if it compounded annually, taking a basic-rate taxpayer over their Personal Savings Allowance for that year.

To get around this trap you could opt for an account where the interest is paid out monthly or annually, meaning it is spread across different tax years. Or you can opt for a fixed-term ISA savings account, where you won't pay any tax on the interest.

*Based on MSE, accurate to 29/08/24

Trap 2: Tax on your child’s savings

A little-known rule means that you might have to pay tax on interest that’s earned on your child’s savings. This sneaky tax rule means that once a child earns £100 or more in interest on money that has been gifted by parents, it is taxed as though it is the parent’s money.

When interest rates were at historic lows, it was not much of a concern. But the top children’s easy-access account pays 5.25%*, which means that once you have more than £1,900 saved, you will hit that £100 limit. If you reach £100 then all that interest (not just the interest over £100) is counted as though it’s the parents’ and will therefore use up some of their Personal Savings Allowance, potentially becoming taxable if they exceed their allowance.

This won’t be a problem if you haven’t earned much taxable interest yourself, but if you’re near (or already over) your Personal Savings Allowance you’ll be hit with unexepected tax. This rule only applies to money gifted by parents, not by money given by other family or friends. And the limit is also per parent.

One way around it is to use a Junior ISA account, where all interest will be protected from tax and won’t count towards the parents’ limit. Or you can carefully split the money you give between parents, to ensure that you are making equal payments to their children, rather than one of you making all the transfers to the child’s savings account. If you have a joint account, the money will be assumed as coming 50:50 from each of you. Or if one of you has any Personal Savings Allowance remaining, you could consider being the one to give your child/children money, as any interest will be added to your own.

*According to moneyfacts.co.uk, accurate to 29/08/2024

Trap 3: Tipped into the next tax bracket

The Personal Savings Allowance is cut in half or wiped out altogether if you move into the next income tax bracket. So if you earn more than £50,270 (even by £1) you’ll become a higher-rate taxpayer and see your Personal Savings Allowance cut from £1,000 to £500. And if you earn more than £125,140 you’ll become an additional-rate taxpayer and see your Personal Savings Allowance drop to nothing – meaning that all your savings income will be taxed at 45%.

One thing lots of people aren’t aware of is that savings interest counts towards this limit. So if you have a £50,000 annual salary you would be in the basic-rate of income tax, pay tax at 20% and have a £1,000 Personal Savings Allowance. However, if you also had £1,000 in savings income you will tip into the higher-rate tax bracket and see your Personal Savings Allowance cut to £500. This means £500 of your savings interest will be taxed and your highest tax rate will BE 40%.

One way around this is using an ISA for your savings, as then the interest won’t count for income tax purposes. Alternatively you could pay some of your income into your pension, which could bring you back into a lower tax bracket. Another option is moving cash savings into an account in your partner’s name, if they pay tax at a lower rate than you or haven’t used up their Personal Savings Allowance yet.

Trap 4: Joint savings account

Lots of people might have savings accounts in joint names, but they may not realise that this means the interest is split 50:50 between the two account holders. It could mean you have taxable interest that you hadn’t realised. For example, a joint savings account that generates £1,000 interest each year would be split so that each partner has £500 interest to count towards their Personal Savings Allowance.

If one half of a couple is a lower earner, and so in a lower tax bracket, it could make sense to move the savings into an account in their name, as any interest that’s taxable will be paid at a lower rate. For example, a higher-rate taxpayer who had £1,000 of taxable interest would pay £400 in tax on the money, while a basic-rate taxpayer would only pay £200 in tax.

Even if both partners are in the same bracket, if one half hasn't exhausted their Personal Savings Allowance you could move savings into their name to maximise their tax-free amounts.

Trap 5: Not realising it’s not just savings interest that counts

Lots of people are aware that their savings interest could be taxed, but many aren’t aware that interest and income from other products counts towards their Personal Savings Allowance and could be taxed too. For example, the interest paid on peer-to-peer lending will count towards your savings limit and could be taxed.

Equally, the interest from some investments and funds could count as interest and count towards your Personal Savings Allowance. With a fund, if the fund invests more than 60% in bonds and cash, then payments from the fund are classed as interest rather than as dividends. Your investment platform or provider will usually send you a tax statement each year to show you how much you’ve made in interest in that tax year, to help with your calculations.

The easiest way to avoid this is to use a stocks and shares ISA for your investments or an Innovative Finance ISA for any peer-to-peer investments you have, so no tax will be due. Another option is moving investments into a spouse’s name if they are in a lower tax bracket or haven’t used up their tax-free allowances yet.