Interest rate rises have recently made headlines for all sorts of reasons, sparking discussions about their impact on society and the economy – will higher rates curb inflation? Who stands to gain the most? What will happen to my mortgage?
Mortgage payers will definitely face challenges, though savers will welcome the higher rates. What has gone somewhat unnoticed until recently, however, is the increase in interest income that many will now be getting on their account balances in savings and current accounts.
And with this there’s a potential tax quandary some will face. Ignorance of the rules won’t stop HMRC sending you a tax bill, so here’s a short summary of what you need to know.
Unknown to many, interest earned through bank accounts is considered income and subject to tax. HMRC provides a tax allowance – the personal savings allowance – for such income in addition to your personal allowance and which varies based on an individual's tax band.
Currently, basic rate taxpayers can earn up to £1,000 interest in a financial year without any tax liability. Higher rate taxpayers have their allowance halved to £500 and individuals in the highest tax band have no allowance at all.
These allowances don’t affect individual savings accounts (ISAs), which are a recommended alternative to saving in regular bank accounts. These have long been an attractive option for savers regardless of income or status. ISAs provide not only a generous benefit to savers but also relief from certain taxes, including interest income and capital gains. ISAs are beyond the scope of this article, but it is worth noting their relevance in the context of interest income and tax planning.
If you’ve not got an ISA, consider opening one as there are limits on how much you can save each year (£20,000 from 6 April to 5 April the following year), and all interest and capital gains are entirely tax-free.
In addition, there is a starting rate for savings where savers may also get up to £5,000 of interest and not pay tax on it. But this is on a sliding scale, so the more you earn from other income (for example wages or pension payments), the less the starting rate for savings will be – every £1 of other income above your personal allowance reduces your starting rate for savings by £1 – but the personal savings allowance is untouched.
With this in mind, it becomes crucial for individuals to understand the tax implications associated with any interest income they earn. Until recently with low interest rates, surpassing £1,000 of interest income was often beyond reach. After all, the best savings accounts often only offered 2-3% interest and current accounts less than 1%. With the higher interest rates we’re seeing now, reaching the threshold has got a whole lot easier.
Banks report to HMRC all interest payments made to their customers, and HMRC will use this information to amend PAYE codes through coding notices to recover tax on interest income – but only for those who are employed and paid through PAYE. Those who are self-employed, and others who complete tax returns, will have to highlight the interest income earned on their tax return and pay any tax due in the normal way.
It gets messier when you consider joint bank accounts. HMRC typically treats interest from joint accounts as split equally between account holders, but there may be specific arrangements to consider which HMRC aren’t privy to, and an election by account holders could be needed if beneficial ownership of the account isn’t straightforward.
The interest income dilemma is not the only thing that may attract a liability. It is also essential to consider other rewards offered by banks as their tax treatments differ. Monthly rewards offered by banks, for example, are considered income much like interest income and is subject to tax (often, account holders will reclaim tax on these as the rewards are paid net of tax), while cashbacks from purchases made using a debit or credit card are not considered income at all and are, in fact, tax-free (HMRC considers these to be discounts on payments made instead).
In addition, children’s bank accounts offer a modest opportunity to reduce tax liabilities, but rules exist regarding tax on children's interest in accounts and which aim to prevent parents from using such accounts as a tax-free vehicle. For example, if a child's savings interest from money given by a parent exceeds £100, it will be attributed to the parent or step-parent and count as part of their personal savings allowance. Grandparents and other adults who give money to children are not liable for tax in this case.
As interest rates rise, understanding the tax implications of interest income becomes an important consideration for both savers and current account holders. Familiarising yourself with the tax allowances based on your tax band as well as the alternatives are essential to the best tax outcomes for your hard-earned money.