Tax on savings interest: everything you need to know

Find out how the new Personal Savings Allowance will impact your tax bill and how to pay tax you owe on your savings interest.

Do you have to pay tax on savings?

Savings interest counts as taxable income, but each year you get an allowance that can reduce your bill.

Since April 2016 your allowance for earning savings interest tax-free is made up of three elements:

• Personal Allowance (£11,000 for 2016/17)
• Starting rate for savings (up to £5,000 for those on low incomes)
• Personal Savings Allowance (up to £1,000 depending on your Income Tax band)

So in theory you could earn £17,000 in savings interest tax-free.

However, your Personal Allowance is usually used up by the income you get from wages or a pension.

The ‘starting rate for savings’ is a tax break that only applies to low earners. It allows those with total taxable income under the Personal Allowance (£11,000 for 2016/17) the chance to earn £5,000 of interest on savings tax-free.

However, each £1 of income you earn above the Personal Allowance reduces the starting rate for savings by £1, so those that earn over £16,000 can’t benefit from this tax break.

The Pesonal Savings Allowance, introduced in April 2016, will allow most people in the UK to not pay any tax on up to £1,000 of savings interest.

Your Personal Savings Allowance (PSA) entitlement differs depending on your Income Tax rate.

Basic rate taxpayers can earn £1,000 on savings interest tax free while higher rate taxpayers get a smaller £500 break. Additional rate taxpayers aren't entitled to a Personal Savings Allowance. 

How savings are taxed

The way savings interest is taxed fundamentally changed on April 6, 2016 with the introduction of the Personal Savings Allowance.

Now, banks and building societies no longer automatically deduct basic rate tax at source so all returns are paid gross.

This means you need to keep an eye on how much savings interest you rack up each year as it’s down to you to settle any extra tax you need to pay on income that exceeds your allowance.

What do the tax-free allowances cover?

Your Personal Savings Allowance (as well as the Personal Allowance and starting rate for savings) applies to interest from:

• Bank and building society accounts
• Non-ISA savings and credit union accounts
• Unit trusts, investment trusts and open-ended investment companies (not dividend distributions)
• Peer-to-peer lending returns
• Government or company bonds
• Life annuity payments
• Some life insurance contracts

Interest earned in cash ISAs, stocks & shares ISAs and some NS&I products (Premium Bonds, Index-linked Savings Certificates etc) don’t count towards your Personal Savings Allowance as they are already tax-free.

Income you receive from dividends has a separate tax-free allowance. Check out The Dividend Allowance: what it is, how to benefit and the best share picks.

When you must pay tax on savings interest

You must pay tax on savings interest earned over your allowance at your normal rate of Income Tax.

So someone that earns £25,000 a year that generated £1,500 in savings interest would be allowed to keep £1,000 tax-free but would have to pay 20% tax on the £500 above their Personal Savings Allowance threshold.

But someone earning £60,000 a year that generated £1,500 in savings interest would get £500 tax-free and would have to pay 40% tax on the £1,000 that exceeds their Personal Savings Allowance threshold.

Can savings interest income push you into a higher tax bracket?

Savings interest counts towards your total taxable income for a year which means it can impact which Income Tax bracket you fall into.

So, if you are a basic rate taxpayer and earn enough interest from savings to enter the higher rate band (£43,000 for 2016/17), you will only be entitled to a £500 allowance for savings interest and will have to pay 40% tax on the remainder.

How to pay the tax you owe on savings interest

If you exceed your Personal Savings Allowance in a tax year you will need to declare it to the taxman and pay the extra tax due.

Banks and building societies and other savings institutions will provide HMRC with information which helps it determine who needs to pay more.

If you are employed or receive a pension, HMRC says it will change your tax code for the upcoming year to collect the tax you owe. You should be issued with a ‘Notice of Coding’ should this need to happen.

Others, like the self-employed must file a Self-Assessment tax return to declare the extra taxable interest they need to pay and make the payment manually.

As the Personal Savings Allowance only came into effect in April 2016 the first Self-Assessment forms will not be due until October 2017.

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