Beware the new Personal Saving Allowance trap

The UK base interest rate has been on the rise in 2022; a double-edged sword for individuals across the country.

On the one hand, a higher base rate usually translates into higher interest rates offered by savings accounts. Conversely, they also tend to mean higher rates on mortgage deals offered by lenders. A less well-known pitfall is the rising spectre of the “Personal Saving Allowance trap” in 2022. This risks catching many people out by surprise, leaving them with an unexpected tax bill. Below, we explain the nature of this trap, how it could impact a tax plan and ways to counter it effectively.

What is the Personal Savings Allowance trap?

Each tax year, a Basic Rate taxpayer is entitled to earn up to £1,000 in interest (e.g. from cash savings) outside of an ISA without paying tax on it. For someone on the Higher Rate, the limit is £500. However, few people have needed to worry about breaching their Personal Saving Allowance in recent years due to low interest rates. In 2020, for instance, the base rate stood at an historic low of 0.10% and it was very difficult to find an easy-access savings account which neared even 1%. This meant that many Basic Rate taxpayers could hold £100,000 or more in cash (outside their ISAs) and not need to worry about paying tax on their interest.

With the Bank of England (BoE) raising the base rate repeatedly since late 2021, however, the situation is changing. Banks started raising their own savings rates earlier this year as markets became more confident of where the base rate would settle. This means that savers can get better returns on their cash. Yet many may assume that they can simply hold the same amount as before (e.g. as they switch to a better account) and not face a tax bill on the higher interest they hope to earn. This may not be the case.

How the Personal Saving Allowance trap could affect you

According to the broker AJ Bell, in December 2021 a Higher Rate taxpayer would have needed £66,666 in their easy-access account (assuming a 0.75% interest rate) to start breaching their £500 Personal Savings Allowance (PSA). However, if this taxpayer moved the money to a 2.1% account then their Personal Saving Allowance would be exceeded after £23,800 of savings. This threshold would go even lower if interest rates rise higher in the coming months. A 4.5% interest rate may mean that £11,100 in savings could lead a Higher Rate taxpayer to start paying tax on interest.

If you are employed or receive a pension, then HMRC is likely to change your tax code on your behalf so you pay any tax on interest automatically (if you go over your allowance). This could lead some people to get a nasty surprise when receiving their pay cheque. Others may need to start filling out a Self Assessment tax return (e.g. if income from savings and investments goes over £10,000), but not be aware of this and be hit by a fine by not declaring this by the deadline. Another risk is that you end up overpaying on tax if HMRC estimates how much interest you will get in the current tax year, but forecasts too much.

A final risk to consider is how the income tax “freeze” may bear upon your savings and the tax you pay. In March 2021, (then) Chancellor Rishi Sunak announced that income tax bands would be frozen until 2026. Many analysts saw this as a stealth tax, as the House of Commons Library published research suggesting that this could bring 1.2m more people into paying the Higher Rate of income tax by 2026 (due to average wages rising). If this happens to someone, then their previously-available £1,000 Personal Savings Allowance is cut in half, to £500. Suddenly, an individual could face tax on their interest where they did not before.

Ideas to avoid the Personal Saving Allowance tax trap

The best way to avoid needless tax on your interest is to speak with a financial planner. Yet you can also explore a range of options alone before a potential conversation. Firstly, consider how much you really need to save in cash. Whilst cash is a useful asset for short term goals - e.g. saving for a mortgage deposit and an “emergency fund” - it is generally poor for building long term wealth. This is because interest rates rarely beat inflation, leading you to lose “real value” on your savings (even if your bank statement shows you have earned interest!). Therefore, it may be wise for some people to simply invest some of their cash savings into other assets, like equities. Not only could this unlock higher potential returns, but it could help avoid a tax trap on your interest from cash savings.

Secondly, cash ISAs could be an option if you need to hold cash which would take you over your PSA if held in normal savings accounts. Each tax year, you can put up to £20,000 into ISAs and generate interest without tax. Here, the main consideration is avoiding an “opportunity cost” when using your ISA allowance on cash, since better returns could be achieved by using this towards investments which can generate capital gains and dividends without tax.

A third option could be to commit some cash savings towards Premium Bonds. These do not offer a regular interest payment and so do not count towards your Personal Saving Allowance. Instead, you enter a monthly prize draw with the potential to win between £0 and £1m, tax-free. Finally, if you pay the Basic Rate for income tax, take care if your income is at risk of entering the Higher Rate in the coming years (which could lower your PSA to £500). One option to address this is to use your pension contributions to keep your effective income below the £50,271 Higher Rate threshold.

Get in touch with your usual Punter Southall Aspire financial planner to discuss  maximising your tax allowances.

Note: The value of an investment and the income from it can go down as well as up and investors may not get back the amount invested.