Big changes to the way bank account interest is taxed

Interesting times

Coming soon: important changes to the way bank and building society account interest is taxed

From 6 April, basic and higher rate income tax payers (but not additional rate income tax payers) will be able to receive interest on some savings in their normal bank accounts tax-free.

Each year, basic rate taxpayers will be allowed up to £1,000 tax-free bank and building society account interest, with higher rate taxpayers allowed £500. This is to be called a Personal Savings Allowance, and applies to interest earned over a tax year starting on 6 April 2016. Additional rate income tax payers will not get this allowance.

Although bank and building society account interest up to these limits is tax-free, the interest you earn still gets taken into account to determine whether you earn more than the various tax thresholds. These include the personal allowance of £11,000 and the income threshold of £43,000, at which higher rate tax starts (2016/17).

An easier process

Unlike the present rules, where non-taxpayers need to fill in an R85 form to receive interest without deduction of basic rate tax, you won’t need to do anything. Instead, interest will be paid gross, without the deduction of tax. 

With interest rates so low at the moment, this means that substantial amounts of cash savings can be held in ordinary bank deposit accounts without the interest being taxed. 

The amount you can shelter tax-free will depend on the interest rate you earn. Here’s how much you can hold if you’re a basic rate taxpayer at various rates of interest.

Annual rate of interest

Amount that can be held by a basic rate taxpayer in an ordinary bank account without paying tax on the interest

0.5%

£200,000

1%

£100,000

1.5%

£66,667

2%

£50,000

2.5%

£40,000

3%

£33,333

And, for higher rate (40%) income tax payers:

Annual rate of interest

Amount that can be held by a basic rate taxpayer in an ordinary bank account without paying tax on the interest

0.5%

£100,000

1%

£50,000

1.5%

£33,333

2%

£25,000

2.5%

£20,000

3%

£16,667

These changes mean you’ll have three options for holding cash tax efficiently:

  • A cash ISA
  • An ordinary bank deposit account or fixed rate/fixed term bond
  • A bank account or fixed-term deposit within your pension 

The rate of interest you earn depends on how long you’re prepared to commit your money. Here are some examples of the best rates around at the moment:

Best cash ISA rates

Best bank deposit rate (gross)

Instant/Easy access - 1.51%

Instant/Easy access 1.45%

1 year - 1.65%

1 year – 1.85%

2 year - 2%

2 year - 2.2%

3 year - 2.3%

3 year - 2.45%

5 year - 2.6%

5 year - 3.11%

As you can see from the table,  fixed term bank accounts (also called  ‘fixed rate bonds’) were providing better rates than ISAs at the time of research. 

Although there is no requirement for providers of ordinary fixed-rate/fixed-term bonds (non-ISA) to offer early access, most providers do allow emergency access to your savings. If you access either a fixed rate ISA or an ordinary fixed rate/fixed term bond early, you should expect to suffer a penalty. This will usually involve forfeiting some of the interest you would have earned. 

So why do non-ISA fixed-term bank deposits both instant access and fixed-term, offer better rates? The simple answer is that the market for non-ISA savings is more competitive, whilst the cash ISA market is dominated by a few large providers.

More power to the ordinary deposit account?

Think carefully before tying up your money for a fixed term. If you access those savings early, an instant/easy access account may have turned out to be the best deal (with the benefit of hindsight).

Given that ordinary deposit accounts offer better rates and will be tax free from 6 April 2016 on the first £1,000/£500 of annual interest, keeping some or all of your cash savings in an ordinary deposit account could make good sense.

Using your Personal Savings Allowance to cover your cash savings allows you to keep your ISA allowance for other savings and investments. For example, you can also invest in stocks and shares via an ISA. 

It’s also worth keeping an eye on cash ISA rates, as providers may improve their ISA rates of interest to stop people moving their cash savings to ordinary bank deposit accounts.

This article is not intended to give advice or a personal recommendation. If you need a personalised recommendation based on your personal circumstances, you should seek financial advice. You can find a financial adviser in your area at www.unbiased.co.uk

AR01605  02/2016

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