Whenever you’re preparing a savings strategy, it’s essential to understand whether tax will need to be paid on any interest or bonuses you earn.

Whether or not you pay tax on savings is dependent on multiple factors, including how much interest you earn every year and how much money you earn as a salary.

Starting in 2016, the rules governing how interest is taxed and how that tax is applied changed in the UK. As a result, many savers are finding themselves asking, 'Do you pay tax on savings?'

In this article, we will explain when UK taxpayers may have to pay tax on their savings, how that tax will be determined, and explore different types of tax-efficient strategies,  accounts, and savings plans that can be used to save money without increasing your tax burden.

Tax is a very complicated subject. Whenever you’re preparing a savings strategy, it’s essential to understand whether tax will need to be paid on any interest or bonuses you earn. This blog is based on our current understanding of tax legislation. Tax treatment depends on individual circumstances and may be subject to change in the future. If you have any questions regarding tax you should speak to a tax expert, which may incur a fee.

Who Has To Pay Tax on Their Savings?

The first thing to understand is that you generally will not pay tax on the capital value of your savings. This means that, if you save £1,000 from your salary, the government will not take any money from this amount, as you have already paid income tax.

Instead, you may have to pay tax on the interest you earn, but only in specific scenarios.

Whether you pay tax on interest depends mainly on two factors: your income tax band and the type of savings account you are using to save.

Income Tax Band

Depending on their level of income, UK residents are permitted to earn a certain amount of interest before it is taxed. This is called a Personal Savings Allowance (PSA), and three tax bands determine how much tax must be paid:

• Basic Rate

• Higher Rate

• Additional Rate

Basic Rate

If you are a basic rate taxpayer, which means that you currently earn less than £50,270 a year, then you will have a Personal Savings Allowance of £1,000.

This means that a basic rate taxpayer can earn up to £ 1,000 in interest without paying tax, but will be expected to pay tax on any interest exceeding that threshold. This limit is provided to allow lower-income households the opportunity to earn a little bit more money before being subjected to additional taxes. 

Higher Rate

If you are a higher rate taxpayer, earning more than £50,271 but less than £125,140, then you will have a PSA of £500, which means you can earn up to this amount before being expected to pay tax. This lower rate adjusts for your higher income, as your higher salary is likely to compensate for the money you will pay in tax.

Additional Rate

If you are an additional rate taxpayer, earning over £125,140 per annum, then your PSA is £0, as your high level of income is expected to compensate for the tax you will pay on interest earnings.

Account Types

After considering your income band and the amount you expect to earn in interest, the next step is to determine the type of account or savings plan you are using to save your money.

Multiple types of savings accounts and savings plans allow you to earn interest without paying any additional tax. In this section, we will break down some of the most popular ways to save money in a tax-efficient manner.

Individual Saving Accounts (ISAs)

The most well-known type of tax-efficient savings account is the ISA, or Individual Savings Account. This type of savings account is intended to encourage people to save money by allowing them to earn interest without paying tax.

Each year, the government sets an annual ISA allowance, which is the maximum amount of money that can be contributed to ISAs during that tax year. Any interest, bonuses, returns or dividends earned within an ISA are tax-free.

There are multiple forms of ISA available, including Sheffield Mutual’s Single Premium Investment ISA, Regular Premium Investment ISA, Investment Junior ISA, Sustainable Junior ISA, Single Premium Sustainable ISA and Regular Premium Sustainable ISA.

ISAs are one of the most popular ways to save, as they offer a high contribution limit and provide a variety of options, including the choice between a Cash ISA and a Stocks and Shares ISA.

Due to the high contribution limit and the wide range of options available, most savers will choose to open an ISA as their first choice for tax-efficient savings.

Please note: Capital at risk. If you withdraw from your ISA during adverse market conditions, you may receive less back than you have invested. 

Tax Exempt Savings Plans

Another way to save money without incurring tax is to invest in a Tax Exempt Savings Plan (TESP). These plans can only be offered by friendly societies, such as Sheffield Mutual, and are not available through other financial institutions.

A TESP allows you to save up to £25 a month or £270 as a one-off annual payment without paying tax on any interest or bonuses that are earned.

When taking out the plan, you will be provided with a ‘sum assured’ at the beginning of your plan. This amount represents the minimum guaranteed amount that you will receive upon maturity, plus any additional bonuses that have been earned during your investment period. If your TESP earns additional bonuses, the value of these bonuses will be calculated based on your Sum Assured, not the amount that has been paid to date. 

If you are considering taking out a TESP, please read our important information document before committing to any investment strategy.

Please note: Capital at risk. If you surrender the plan before maturity (which is the term you select when first starting the plan), you may get back less than you have paid in. 

Children’s Tax Exempt Savings Plan

In addition to opening a TESP for yourself, you can also contribute to a TESP on behalf of your children, or any child you care about.

Like our standard plan, a Children’s Tax Exempt Savings Plan allows our members to contribute between £5 and £25 a month, or £270 annually, for a period lasting between 10 and 25 years. These are the maximum contributions you can save across all tax-exempt plans with any friendly societies combined, per policyholder. 

The money saved in this plan will aim to earn regular tax-free bonuses. Like our standard TESP, a children’s plan will also receive a sum assured at the beginning of your investment period, guaranteeing a minimum return as long as payments are made regularly.

In addition, the bonuses earned by a Tax Exempt Savings Plan are calculated based on the sum assured that was received at the beginning of the investment period, not the value of the money you have paid in, meaning that you won’t be penalised for being early in your savings journey.

If you are considering opening a Children’s Tax Exempt Savings Plan, please read our important information document before committing to this investment strategy.

Please note: Capital at risk. If you surrender the plan before maturity (which is the term you select when first starting the plan), you may get back less than you have paid in.

Discover A Tax-Efficient Way To Save With Sheffield Mutual

At Sheffield Mutual, we offer a range of products that have been designed to help our members save money efficiently. We are not tax experts or tax advisers, but if you are interested in contributing to an ISA or opening a Tax Exempt Savings plan, Sheffield Mutual’s friendly team are available to help open and manage your account.

If you are interested in becoming a member of Sheffield Mutual or you have a question about one of our plans, feel free to contact us online or by calling 01226 741 000.

Tax treatment depends on individual treatment and is subject to change. Sheffield Mutual are not tax experts. If you have questions regarding your tax treatment, you should speak to a tax expert, which may incur a charge.

This article provides generic information and the writer's opinions and should not be relied upon for investment decisions. Sheffield Mutual has provided no advice. If you doubt whether a savings or investment plan suits you, consider contacting a financial adviser for advice. If you do not have a financial adviser, you can get details of local financial advisers by visiting www.unbiased.co.uk or www.vouchedfor.co.uk. Advisers may charge for providing such advice and should confirm any costs beforehand.