Martin Lewis has clarified how tax on interest earnings work as many people don’t understand the rules. The financial expert and founder of Money Saving Expert was asked to explain when interest earnings are taxable, in a call on his BBC podcast.
Those approaching retirement or who have just retired may want to check over their accounts as there is a risk you could overpay tax. There is a starter rate for savings allowing you to earn £5,000 a year interest, which reduces by £1 for each £1 you earn over the personal allowance, of £12,570 a year. This means once you earn £17,570 a year, you get no starter rate.
However, those on the basic rate of income tax can earn up to £1,000 a year in interest without paying tax on the amount. Any of your interest earnings that are taxable will be taxed in line with your income tax rate, which is 20 percent for basic rate taxpayers and 40 percent for those on the higher rate.
Those on the higher rate only get a £500 allowance, while those on the additional rate get no savings allowance and pay 45 percent tax.
You can also deposit up to £20,000 a year into ISAs, where any interest earnings or investment growth are tax-free.
The key rule for when your interest earnings become taxable
Mr Lewis set out the key rule to note here: “What triggers the interest counting for tax purposes, is the first moment that the interest is accessible to you.”
He said this means that for easy access accounts where you can withdraw funds at any time, the interest is taxable and goes towards your annual allowance “at the moment it is paid”. But the matter is more complex when it comes to fixed rate savings.
Mr Lewis said: “Let’s imagine a fixed savings account where you’ve got a two-year fix and the money is locked in for that period, but the interest is paid annually.
“So you open the account, after one year the money is paid. Many people think the money has been paid, there for it accrues at the point. It doesn’t, because it’s a fix and your money is locked away and you cannot access the interest even though it has been added to your account, that interest is not taxable until the point that you can access it, which on a fixed would be after two years, after the account closes and you can then take the money out.
“Interest is taxable at the moment you would first access it. You don’t have to access it, it’s the moment it’s accessible.” The savings expert went on to voice concerns about how this could impact some savers.
He said: “If you earn less than £10,000 interest and you don’t do self-assessment, the savings provider notifies HMRC of the interest that you earn and your tax code is reduced so that you pay the interest that way.
“My concern is they often report interest when it is paid but on some accounts, it should be interest when it it accessible.” If you earn £10,000 a year or more from interest earnings or invesments, you have to do self-assessment.
Pensioners could be paying too much tax
Mr Lewis gave the example of a person with a fixed rate account with a three-year term paying interest each month, who opened it the year before they retired. If they were on the higher rate of income tax, paying 40 percent, during that first year, there is a risk they could overpay tax.
The expert said: “In that first year, if the savings provider is reporting to HMRC that you’ve earned interest, and HMRC is taxing you as if you earned interest in that year, it would be taxing you if you were above your personal savings allowance, at the higher tax rate.
“But because you can’t access that interest until the third year, the interest should have accrued after three years. Because you’ve now retired, you are now just a basic rate 20 percent taxpayer, and the interest should technically have accrued then.
“So you should be paying 20 percent interest, not 40 percent interest on it.” He went on to warn this issue may affect a large number of people.
Mr Lewis said: “Now we believe, we’re struggling to find this, that many people are in that relatively niche circumstance, paying too much tax on their savings because it’s been reported when it’s been paid, not when it’s accrued.
“As HMRC does it automatically, people don’t see this. So that is something that my team and I are in the midst of investigating and not fully there on.”