The new personal savings allowance means some will be better off earning LESS interest

Until now for every £100 of interest a basic-rate taxpayer earns outside an ISA, the taxman takes £20. Yet on 6 April, the savings landscape changes. 

The new personal savings allowance (PSA) means ALL basic-rate taxpayers will be able to earn £1,000 a year interest on all savings, higher rate £500, tax-free. But within the way this works there is an anomaly that can mean a few people would be better off to earn less interest.

Before I take you through that let’s first run through the new allowance in brief (this ISN’T full info though, to find out everything you need to know do read my Personal Savings Allowance guide)…

  • Basic 20% rate taxpayers will be able to earn £1,000 interest tax-free.
  • Higher 40% rate taxpayers will be able to earn £500 interest tax-free.
  • Top 45% rate taxpayers won’t get a personal savings allowance.
  • For any earnings above the PSA you pay tax on the interest at the relevant income tax rate.
  • The PSA includes interest from savings accounts, bank accounts, credit unions, and even peer-to-peer savings. It does not include dividends from shares (though the allowance for those is changing too).
  • Savings interest will now be paid gross (ie, with no tax taken off) as a default.
  • Interest earned from ISAs or other tax-free products won’t count towards your PSA (so they can’t push you over the limit).

As you can see this is going to be a game changer for savings, as it means things like high interest bank accounts which pay up to 5% will be tax-free. For a full guide to where you should now save see my new savings fountain.

So why would some be better off earning less?
As you can see the amount of PSA you get all depends on which tax band you’re in.

From 6 April the standard personal allowance (the amount you can earn tax-free from any source) increases to £11,000. You will then pay 20% tax on the next £32,000. Therefore most people will start paying higher-rate tax only if they earn over £43,000.

Yet this amount isn’t just for earned income from work, it includes other earnings from things such as rental income, self-employment and interest from savings accounts (not ISAs).

In other words you need to add up all your income, including savings interest, as that is what defines how big your PSA will be. If your total income is below £43,000 you get a £1,000 PSA, if it’s above you get £500.

Time for two scenarios…

Scenario 1: Near the limit but not over it

Income from work: £42,000
Interest from savings accounts: £990
Total income: £42,990 – so less than the higher-rate threshold
Size of PSA: £1,000
Total amount of interest earned after tax: £990 as all your interest is covered by the PSA

In this scenario all of your savings interest would be tax-free.

Scenario 2: You earn £20 more savings interest, but take home LESS

Income from work: £42,000
Interest from savings accounts: £1,010
Total income: £43,010 – so you are a higher-rate taxpayer
Size of PSA: £500
Total amount of interest earned after tax: £906 (£500 tax-free, £500 taxed at 20% and £10 taxed at 40%)

Therefore, bizarrely, the fact you’ve earned slightly more interest means because a chunk more of it is taxed you actually end up taking home less. You would actually have been slightly better off to have earned £10 less interest.

A similar situation will occur for those at the brink of hitting the £150,000 earnings barrier where you become a top 45% rate taxpayer.

Should I be worried about this?
I’ve had to play with the numbers to come up with this scenario – you have to have non-savings earnings just below the £43,000 threshold, with savings interest taking it near the PSA limit and above it by no more than around £100 before a risk of you being worse off. If that did happen one easy option if you’re in a trusted relationship is just give some money to your partner to save in their name.

But overall this is a very rare scenario and the new PSA will still make you better off than you would’ve otherwise been.

So the golden rule is still try to make as much interest as possible

My real reason for highlighting this particular anomaly is to draw attention to the issue of ‘what counts as being a higher-rate taxpayer?’ and the fact that your interest earned from savings counts towards it.