You may have seen headlines about rising interest rates over the past few years, and this could have affected your finances in several ways.
For example, you could have seen an increase in your mortgage costs, putting pressure on your budget.
On the other hand, you may have benefited from a more favourable interest rate on your cash savings, making it easier to grow your wealth. Yet, higher returns on your cash savings could mean that you’re more likely to pay Income Tax on these in the future.
In fact, according to IFA Magazine, the latest estimates suggest more than 2.1 million people will pay tax on their cash savings interest in 2024/25.
Read on to learn why this is and how you could potentially reduce your bill.
You may pay tax on interest that exceeds your Personal Savings Allowance
You may hold wealth in a cash savings account to act as an emergency fund or to save for short- to medium-term goals such as a holiday or home repairs.
If so, it’s important to consider the tax you could pay on any interest that you earn.
Your Personal Savings Allowance (PSA) is the amount of interest you can earn on cash savings held outside of an Individual Savings Account (ISA) without paying tax. Any interest that exceeds the PSA is normally taxed at your marginal rate of Income Tax.
In 2024/25, the PSA is:
- £1,000 if you’re a basic-rate taxpayer
- £500 if you’re a higher-rate taxpayer
- £0 if you’re an additional-rate taxpayer.
Being aware of how much interest you generate, and what your PSA is, could help you potentially mitigate a large Income Tax bill.
Cash savings interest rates increased significantly over the past few years
Inflation rose rapidly between 2021 and 2023 as the Covid-19 pandemic and the war in Ukraine caused a worldwide increase in the cost of living.
Indeed, the Office for National Statistics (ONS) reported that inflation reached a peak of 11.1% in the 12 months to October 2022.
In response to rising inflation, the Bank of England (BoE) increased its base rate – the interest rate it charges to other financial institutions – 14 consecutive times between December 2021 and August 2023. Between August 2023 and August 2024, the base rate stood at 5.25%.
This made borrowing more expensive, meaning you may have had less disposable income. Higher interest rates also made saving more attractive. As such, the intention behind raising the base rate during periods of high inflation is to encourage consumers to spend less and save more, causing price rises to slow.
The strategy was successful and the ONS reports that inflation fell to 1.7% in the 12 months to September 2024.
As a result, the BoE reduced the base rate from 5.25% to 5% on 6 August 2024, and again to 4.75% on 7 November 2024.
While borrowing became more expensive during this period, interest rates on cash savings increased significantly and remain relatively high at the time of writing.
For example, Finder reports that in September 2021, the average interest rate on an easy access cash savings account was 0.11%. If you had held £50,000 in this account, you would have earned just £55 in interest. As this is within your PSA, you wouldn’t have paid any tax.
In comparison, Moneyfacts reports that on 7 November 2024, the best easy access savings account interest rate was 5%.
The same £50,000 in this account would generate £2,500 in interest. If you’re a higher-rate taxpayer with a PSA of £500, you would pay Income Tax at your marginal rate on the remaining £2,000. This would leave you with a bill of £800.
Or, as an additional-rate taxpayer with no PSA at all, you could pay £1,125.
While inflation has now fallen and interest rates may follow suit, you could still be more likely to pay tax on your cash savings interest than you were in the past.
Indeed, according to IFA Magazine, figures show that 1.9 million people paid on their savings interest in 2023/24, and this could increase to almost 2.1 million in 2024/25.
Fortunately, there are several ways you could potentially reduce your bill.
3 ways to reduce the tax you pay on your cash savings interest
1. Use your full ISA allowance
ISAs are an incredibly popular tax-efficient saving and investment vehicle. This is because you don’t pay Dividend Tax, Capital Gains Tax (CGT), or Income Tax on returns or interest you generate from wealth in an ISA.
You could consider opening a Cash ISA instead of using an easy access savings account. Doing this means you can save your wealth and generate interest without paying Income Tax on that growth.
In the 2024/25 tax year, you can contribute up to £20,000 across all adult ISAs. Each person has their own ISA allowance too, so you and your partner could save up to £40,000 between you tax-efficiently.
You can also contribute up to £9,000 to a Junior ISA on behalf of a child or grandchild.
Making use of all your ISA allowances could help you reduce the tax you pay on your cash savings interest.
2. Consider tax-efficient savings alternatives
If you have already used your ISA allowance for the year and want to contribute more to cash savings, you may want to explore other tax-efficient options such as Premium Bonds.
Every £1 you hold in Premium Bonds gives you one entry into a monthly prize draw, with prizes ranging from £25 up to £1 million. All prizes you win are usually tax-free, so Premium Bonds could generate some tax-efficient returns.
That said, you could win small prizes or nothing at all, so the returns from Premium Bonds may not deliver the consistent growth you require.
It could be useful to seek professional advice to determine the most suitable ways to hold your cash savings.
3. Explore tax-efficient investment options
Holding some cash savings as an emergency fund could be useful for protecting you against financial shocks. If you face unexpected home repairs or need to replace your car, for example, you can cover these expenses without relying on expensive borrowing.
You might also build cash savings for short- to medium-term expenses in the next few years, such as a holiday.
However, if you hold a large amount of surplus cash in addition to your emergency fund, you could be more likely to pay tax on your savings interest.
If you’re looking to build wealth in the long term, it may be sensible to invest surplus funds instead of holding them in a cash savings account. There are several tax-efficient investing options to consider.
For instance, you can invest through a Stocks and Shares ISA, enjoying the benefits of the tax wrapper discussed earlier. Consequently, you won’t pay any tax on the returns you generate.
Alternatively, you could consider paying additional funds into your pension, especially if you’ve already used your ISA allowance. You’ll benefit from tax relief on your contributions and your savings will be invested, so may grow over time.
This could mean that you see higher returns than you would from a cash savings account and any growth is tax-efficient.
That said, you won’t normally be able to access your pension funds until age 55 (rising to 57 in 2028). Consequently, you may want to ensure you build enough cash savings to act as an emergency fund and meet short- to medium-term goals before contributing to your pension.
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Please note
This article is for general information only and does not constitute advice. The information is aimed at retail clients only.
Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.
The Financial Conduct Authority does not regulate tax planning.
The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.
Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.
A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future performance.
The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates, and tax legislation may change in subsequent Finance Acts.