Starting early in 2021, the rate of inflation in the UK rose rapidly, eventually reaching a peak of 11.1% in October 2022. Energy costs were a big driver of inflation after the Russian Invasion of Ukraine, and you likely noticed other expenses increase too.
In response to high inflation, the Bank of England (BoE) increased its base rate 14 consecutive times. In turn, banks, building societies, and other lenders increased their interest rates.
This made borrowing more expensive, meaning that consumers had less disposable income. It also made saving more attractive, so individuals spent less money and price rises slowed.
Fortunately, the strategy was a success and according to the Office for National Statistics (ONS), inflation fell to the BoE’s annual target of 2% in the 12 months to May 2024 and remained at this level in June 2024.
As a result, the BoE decreased the base rate from 5.25% to 5% on 1 August 2024.
However, on 14 August 2024, the ONS reported that inflation rose slightly to 2.2% in the 12 months to July 2024. This could mean that the BoE delays future base rate cuts, or even increases the rate again if inflation continues rising.
Consequently, interest rates could remain at their current levels for a while longer.
Over the past few years, high interest rates may have caused an increase in borrowing costs but they have also benefited savers who saw their wealth grow faster.
However, the combination of high interest rates and high inflation over the past few years could mean that you pay more tax on your cash savings interest.
Indeed, according to MoneyAge, savers are expected to pay £10.4 billion in tax this year.
High interest rates could mean you use your “Personal Savings Allowance” faster
Interest rates rose considerably in recent years as the BoE took measures to control inflation so you may have been able to find more favourable rates for your cash savings.
For example, Finder reports that the average interest rate on a 1-year fixed-rate ISA in October 2021 was 0.41%. Two years later, in October 2023, the average interest rate on a similar account had jumped to 5.48%.
Interest rates have fallen slightly since then, but the average interest rate on a 1-year fixed-rate ISA was still 4.52% in June 2024.
This may mean that you can generate more interest on your cash savings than you previously could. While this is good news, it’s important to consider what tax you might pay on that interest.
Your “Personal Savings Allowance” (PSA) is the amount of interest you can earn on your cash savings without paying tax. Any interest that exceeds your PSA is taxed at your marginal rate of Income Tax.
In the 2024/25 financial year, the PSA is:
- £1,000 for basic-rate taxpayers
- £500 for higher-rate taxpayers
- £0 for additional-rate taxpayers.
So, if you’re a higher-rate taxpayer and you have £50,000 in a savings account with an interest rate of 4.52%, you’d earn £2,260 in interest.
After applying the PSA of £500, you would pay 40% tax on the remaining £1,760. This would give you a tax bill of £704.
If you’re an additional-rate taxpayer with no PSA, you would pay £1,017.
So, higher interest rates may mean that you see more growth, but they also mean that you’re more likely to pay tax on your savings interest.
“Fiscal drag” might pull you into a higher tax bracket
If you’re in a higher Income Tax bracket, you have a lower PSA, or none at all, and you’ll also pay tax on your cash savings interest at a higher rate.
Unfortunately, “fiscal drag” could pull you into a higher tax bracket in the future, if it hasn’t already.
Fiscal drag describes a situation where Income Tax thresholds remain frozen, while average earnings increase. As a result, more of your earnings exceed the threshold and, in some cases, you could even be pulled into a higher tax band.
This is becoming more likely as Income Tax thresholds are frozen until 2028. In fact, Professional Paraplanner reveals that almost 1.9 million more people will pay higher-rate tax for the first time in 2024 as a direct result of fiscal drag.
Consequently, you could pay tax on a larger portion of your cash savings interest and pay a higher rate.
The combination of high interest rates and fiscal drag mean that savers are expected to pay £10.4 billion in tax on their cash savings interest this year.
Fortunately, there are several ways to potentially reduce the tax you pay.
Using your full ISA allowance could help you reduce your tax bill
Perhaps one of the easiest ways to reduce the tax you pay on your cash savings interest is to take advantage of your ISA allowance.
This is because you don’t pay Income Tax, Dividend Tax, or Capital Gains Tax (CGT) on wealth held in an ISA. So regardless of how much interest you generate, it won’t count towards your PSA.
You can contribute up to £20,000 across all your ISAs in the 2024/25 financial year. Using the full allowance before saving elsewhere could help you mitigate a large tax bill.
You could consider increasing your pension contributions instead of paying into cash savings
If you’ve already used your ISA allowance for the year, and want to save more wealth, you could increase your pension contributions instead of paying into cash savings.
This might benefit you as you won’t pay tax on the wealth you pay into your pension. Additionally, you’ll benefit from tax relief at your marginal rate of Income Tax, and your wealth is invested. This could mean that you see more growth than you would if you put the same amount in a cash savings account.
However, in most cases, you won’t be able to access the funds until you are 55, so this might not be the most suitable option for you.
Often, it’s useful to hold a certain amount in cash savings as an emergency fund, and then consider investing or contributing any additional wealth to your pensions. This could mean that you’re better able to grow your wealth and you don’t pay as much tax.
Get in touch
For more information on how we can help you explore the most tax-efficient ways to hold your wealth, get in touch or email us at advice@mlifa.co.uk.
Please note
This blog 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 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.