Two million to be hit with tax on savings – how to avoid sneaky tax traps

More than two million people will face a tax bill on their savings interest this tax year, as rising interest rates and frozen tax thresholds have pushed more people into these tax bills.

While it might be too late to solve the tax bill for the current tax year, you can organise your savings and sidestep some sneaky tax traps to avoid being landed with an unexpected tax bill next year.

Who is paying the tax?

A previous Freedom of Information request from AJ Bell found that 2.07 million people would end up paying tax on their cash savings in the 2023/24 tax year, up from around 650,000 just three years ago. The number of basic-rate taxpayers being hit with the tax will near 1 million people, up from just half a million in 2022/23.

The thorny issue is that lots of people won’t realise they owe tax until a brown letter lands on their doormat. While those filling out a self-assessment tax return will declare any savings interest, and subsequent tax due, those taxed under PAYE get any tax liability calculated by HMRC, based on information sent to them by banks and building societies. Often this will then mean your tax code is adjusted and you repay the tax through your payslip each month – eating into your take-home pay.

Source: HMRC/AJ Bell. The 2020-21 and 2021-22 figures are outturn based on the 2020-21 and 2021-22 Survey of Personal Incomes (SPI) respectively. The 2022-23, 2023-24 and 2024-25 estimates are based on the 2021-22 SPI

How to beat the savings tax traps

Lots of people may have racked up a hefty tax bill already this year, because they didn’t realise they’d breached their Personal Savings Allowance. The Personal Savings Allowance is £1,000 for basic rate taxpayers and £500 for higher rate taxpayers. Additional rate taxpayers get no exemption and pay tax on all cash interest they receive outside a tax wrapper.

While April brings the fresh slate of a new tax year and many can fix the problem for next year, if you have large savings outside an ISA you’ll need to get started now, to use up the current tax year’s allowances.

Since the introduction of the Personal Savings Allowance lots of savers shunned ISAs. But that decision is hitting some savers’ pockets now, as many find they have too much money to move it into an ISA in one year. The annual ISA limit of £20,000 is generous, but if you’ve spent years accumulating savings outside of an ISA you might find you hit that limit pretty quickly when you want to transfer your money into the tax efficient account.

If you have ISA allowance remaining this tax year, consider whether you should move some cash into an ISA. Equally, if you have a partner you could split the cash savings between you to use up both ISA allowances. If your partner pays income tax at a lower rate, it might make sense to move any savings that will attract tax into their name. Just make sure the savings interest doesn’t tip them into the next tax bracket and undo all your good organising work.

It’s also worth considering whether you are unnecessarily hoarding cash. While cash interest rates are looking pretty decent at the moment, it’s generally not a great idea to have lots of cash for the long term. While we’re in a current sweet spot where savings rates are higher than inflation, generally that’s not the case and that means any money sitting in cash accounts will be losing spending power over the long term.

That doesn’t mean you should invest all your cash. You should have enough for your emergency fund and any money you know you’ll need in the next five years, such as a big holiday, moving house or a new car. After that you need to think about why you are holding cash and whether you would be better off investing it

Four tax traps to avoid

There are lots of ways people might be caught out by a tax bill on their savings, not realising that they might owe tax on their cash. Here are four ways the tax might sneak up on you and land you with an unexpected bill.

Trap 1: Fixed-rate accounts

Many savers are locking into fixed-rate accounts for guaranteed returns, but few realise the tax risk. Interest is taxed when it becomes accessible, so if your account pays at maturity, years’ worth of interest lands in one tax year, potentially pushing you over your Personal Savings Allowance.

Longer-term accounts are most at risk. For example, £7,000 in a top three-year fix at 4.63% would generate £1,018 interest at maturity, exceeding a basic-rate taxpayer’s £1,000 Personal Savings Allowance. To avoid this, choose an account that pays interest monthly or annually, or opt for a fixed-term ISA to keep your interest tax-free.

Trap 2: Children’s accounts

If your child earns more than £100 interest on money you’ve gifted, it’s taxed as yours. With top children’s accounts paying 5%, just £2,000 in savings could hit this threshold. Once that limit is breached, all the interest (not just the excess above £100) counts as the parent’s income, eating into their Personal Savings Allowance and potentially becoming taxable.

To sidestep this, use a Junior ISA or split contributions between each parent to make sure the tax hit is spread. Equally, if one parent has Personal Savings Allowance left, they should be the one to contribute.

Trap 3: Savings interest pushing you into a higher tax bracket

Your Personal Savings Allowance shrinks if you cross into the next income tax threshold. If you earn more than £50,270 your allowance drops from £1,000 to £500, and if you earn more than £125,140 it vanishes completely, meaning all savings interest is taxed at 45%.

But bear in mind that savings interest itself can tip you over. A £50,000 salary plus £1,000 savings interest makes you a higher-rate taxpayer, cutting your Personal Savings Allowance to £500 and leaving £500 of interest taxable at 40%. The solutions are to use an ISA to shelter savings, pay more into your pension to stay in a lower tax band, or shift savings to a lower-earning partner.

Trap 4: Joint accounts

Joint savings accounts split interest equally between holders, which could create unexpected tax bills. A £1,000 interest payout is split into £500 each, which would push a higher-rate taxpayer over their Personal Savings Allowance if they have other cash savings interest.

If one partner earns less, it may be tax-efficient to move savings into their name. A higher-rate taxpayer would pay £400 tax on £1,000 interest, while a basic-rate taxpayer would pay just £200. Even if in the same income tax bracket, using a partner’s unused Personal Savings Allowance can reduce a couple’s tax bill.