Why Pay Tax On Your Savings?

Don't hand over up to 40% of your savings interest to the taxman. Try these tax-free savings accounts instead!

Last Monday, in Where Have All The Savers Gone?, I warned that the UK's savings ratio (the proportion of our take-home pay which we save) has collapsed.

In 1995, we Brits saved a little over a tenth (10.2%) of our disposable income. By 2006, this proportion had halved to a twentieth (5%). Even worse, in the first three months of this year, the savings ratio collapsed to just 2.1%, so we're presently saving only one pound of every fifty that we take home. This is the lowest savings ratio since 1960, so our ability to save is at a 47-year low.

The big question is what's discouraging people from saving -- the old-fashioned art of putting spare cash on deposit? After all, five quarter-point hikes have taken the Bank of England's base rate from 4.50% a year to 5.75%, so savings interest rates are on the rise. Then again, we Brits may be put off by confusion caused by too much choice, because there are well over four thousand different savings accounts from which to choose!

One possibility is that saving has fallen out of favour because, after accounting for tax and inflation (the tendency for consumer prices to rise over time), the returns from most savings accounts are pretty poor and, in some cases, even negative.

For example, let's say that you have a middle-of-the-road savings account (neither a Best Buy nor a shocker, but somewhere in-between) which pays a yearly interest rate of 4% before tax. If you're a basic-rate taxpayer, then you'll lose a fifth (20%) of your interest to HM Revenue & Customs, which reduces your before-tax (gross) rate to an after-tax (net) rate of 3.2%.

If you're a higher-rate (40%) taxpayer, then you face double the damage from the taxman, with your net rate falling to a mere 2.4%. With the Retail Prices Index (RPI) measure of inflation running at an annual rate of 4.3% in May, this means that the buying power of your savings is shrinking by almost 2% a year in this example. Ouch!

So, what can you do to boost the spending power of your savings? You should do two things: boost the interest rate which your nest egg earns, and avoid paying tax. The most popular way to do this is to stash your cash in a tax-free savings account known as a cash ISA (ISA is short for Individual Savings Account).

You can deposit up to £3,000 per tax year in a cash ISA (rising to £3,600 from the 2008/09 tax year) and earn tax-free interest on every penny. The only real drawback with a cash ISA is that if you have deposited the full £3,000 in one tax year, then you cannot replace any withdrawals made thereafter. Instead, you'll have to wait until the next tax year begins and put money into the next year's ISA allowance.

So, how much can you expect to earn inside a table-topping Best Buy cash ISA?

Best Buy Cash ISAs

(for new money, not transfers; based on a balance of £1,000+ with no notice or easy access)

So, there you have it: it's possible to earn in excess of 6% a year on your emergency fund, nest egg or rainy-day money without paying any tax whatsoever. So, a couple opening two cash ISAs and depositing the full £3,000 each in the above NS&I ISA could earn tax-free interest of £378 over the coming year on this £6,000.

Finally, if you're a super saver and can afford to sock away more than three grand a year, then you'll find more tax-free savings products in Top Tax-Free Savings and Tax Havens For Investors.

Here's wishing you superior savings success!

More: Check out the Fool's ISA centre.