The expert warned many people don’t realise how the tax rules work
Martin Lewis has shared some guidance on how tax on interest earnings works, warning that many people don’t understand the rules. The finance expert and founder of Money Saving Expert was asked to clarify when interest earnings become liable for tax, in a listener’s call on his BBC podcast.
People nearing retirement or those who have recently stepped down from work may want to check over their accounts, as there’s a danger they are overpaying tax. HMRC rules state there is a starter rate for savings that permits you to pocket £5,000 annually in interest, but this diminishes by £1 for every £1 you earn above the personal allowance of £12,570 per year.
This means once your annual earnings hit £17,570, the starter rate disappears entirely. Nevertheless, basic rate income tax payers can also pocket up to £1,000 yearly in interest tax-free.
Any taxable interest earnings will face taxation aligned with your income tax bracket – 20 percent for basic rate taxpayers and 40 percent for higher rate earners. Higher rate taxpayers can earn just £500 a year interest tax-free, while additional rate taxpayers get no savings allowance whatsoever and face 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 highlighted the crucial principle to remember: “What triggers the interest counting for tax purposes, is the first moment that the interest is accessible to you.” He explained this means for instant access accounts where funds can be withdrawn whenever you want, the interest becomes taxable and counts towards your annual allowance “at the moment it is paid”.
However, the situation becomes more complicated regarding fixed rate savings products. Mr Lewis explained: “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 went on to express some concerns about how this might affect certain savers.
Pensioners could be paying too much tax
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 or more from interest or investments growth, you have to do self-assessment.
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.” The expert went on to warn this issue may affect a surprisingly 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.”
