4 ways to reduce tax on savings interest

More than a quarter of savers are in the dark about how much interest they're earning, a survey from Hargreaves Lansdown reveals. But not knowing your savings interest rate could risk you sleepwalking into an unwelcome tax bill.

That's because record-high savings interest rates over the past two years mean that a rising number of savers, even with those with modest pots, are now liable to pay tax on the interest they earn. New HMRC data estimates savers will collectively pay more than £10bn in tax on interest this financial year, up nearly ten-fold from the £1.4bn they paid in 2021-22. 

There are (legitimate) ways to cut your savings tax bill. Here, Which? explains what savers need to know about tax on interest and how to make sure you keep more of the returns.

What tax do you pay on savings?

Interest you earn on savings is potentially subject to income tax, at the same rate as the tax you pay on income from employment or self-employment. Most people get a personal savings allowance (PSA), which shields a portion of interest earned on savings from income tax. The PSA currently stands at £1,000 for basic-rate taxpayers and £500 for higher-rate taxpayers. Additional-rate taxpayers don't have a PSA, meaning all their savings interest is subject to income tax.

But the savings balance required to exceed the PSA has shrunk considerably over the past couple of years, thanks to rising savings rates. The best one to two-year fixed-term savings account currently offers around 5% AER. At this rate, a basic-rate taxpayer would need a balance of just over £20,000 to breach their PSA, assuming no other savings income. A higher-rate taxpayer would only need £10,000 in their account before they had to start paying tax on interest.

New HMRC data shows how much more is now being paid in tax on savings interest. In 2023-24, £9.1bn was taken. This financial year, a haul of £10.4bn is predicted. That's almost 10 times more than the £1.4bn paid by savers in 2021-22.

Despite more people falling into this savings tax trap, research by savings and investment platform Hargreaves Lansdown found a worrying number of savers could be unaware they are at risk of receiving a bill from HMRC. It found that 27% of people don’t know what interest rate they’re getting on their savings.

• Find out more: tax on savings interest and investment income

How to minimise your savings tax bill

There are a few ways to reduce how much of a cut HMRC will take from your savings returns.

1. Maximise your Isa allowance

You can save up to £20,000 a year into an Isa, tax free. Savers can deposit the full allowance into a cash Isa, a stocks and shares Isa, or an innovative finance Isa, or split the allowance across the three types. 

With savings rates high, and more savers incentivised to seek tax-free savings options, cash Isas have seen a surge in popularity. Savers poured £16.5bn into these accounts during April and May 2024.

New rules that come into force from April also enable savers in search of higher returns to easily move between different providers. Double-check the terms and conditions before you open an Isa account. However, as Which? found, many banks are not offering the new flexibility when it comes to their own products.

• Find out more: best cash Isas 2024

2. Split your savings

Splitting your savings across several fixed-rate accounts of varying terms means you can spread out the interest payments across different tax years, and potentially reduce your tax bill.

For example, provided you don't need immediate access to the money, a large lump sum could be distributed evenly across one, two, three, four and five-year fixed-term savings accounts. If you choose to have the interest paid upon maturity, then the income earned on your nest egg will also be spread across several different tax years and won't take such a big bite out of your PSA.

• Find out more: how to find the best savings account

3. Consider premium bonds

You can hold up to £50,000 tax free in premium bonds. While premium bonds don't pay any interest, every month you'll be entered into a prize draw with a chance of winning anything from £25 to £1m. 

Just be aware that for every millionaire jackpot winner there will be many, many people not winning anything at all. It really is the luck of the draw.

• Find out more: premium bonds – are they worth it?

4. Take advantage of the starting rate for savings if you're on a low income

Lower-income savers may benefit from this tax break, which currently allows you to earn up to £5,000 in savings income without paying tax. However, to be eligible for any of this allowance you'll need to earn less than £17,570 from other income sources. 

If that's you, here's how it works. Every £1 of other income (from work or a pension, for example) above your standard income tax-free personal allowance of £12,570 reduces your starting rate for savings by £1. So, let's say you earn £15,000 a year. You'll have £2,430 of taxable income. Your starting rate for savings will be reduced by the same amount. After deducting that from the £5,000 cap, it means you can earn up to £2,570 in savings interest without paying a penny in tax.

How do I pay tax on savings interest above my personal savings allowance?

Interest on savings is usually paid gross, which means tax isn't automatically deducted before interest is paid. If you're employed or receiving a pension, HMRC will normally change your tax code to obtain the tax owed from your income. This happens automatically for savings interest.

If you usually complete a self-assessment tax return, you'll need to report any interest when you fill it in. You'll also need to use self-assessment if you earn more than £10,000 from savings and investments in a year.