Everyone is looking for savings and investment products that allow them to earn a reliable return. But what share of that is going to be claimed by the the taxman? Since a change in policy two years ago, the answer is not as much as you might think.
Thanks to the introduction of the personal savings allowance, everyone can now earn up to a certain amount of interest completely tax-free.
How does it work?
Under the allowance, introduced in 2016, annual interest payments of up to £1,000 (for basic rate taxpayers) and £500 (at the higher rate) are exempt from income tax. Any interest received beyond the allowance is then taxed as income at your normal rate. As a result, where you would once have received net interest (minus income tax) from your bank or building society, you now get the gross interest as standard.
What qualifies for the allowance?
The important distinction is between income earned in interest, and that received through dividends. Anything that counts as an interest payment – including from any savings accounts or peer-to-peer investments – qualifies for inclusion.
Investment funds are more complicated. Income from those that pay interest – which typically include those with an emphasis on bonds over equities – will count as part of your allowance.
By contrast, any earnings from funds that pay in dividends cannot be treated as part of the personal savings allowance, and will be taxed as income.
So check your fund investments carefully, to see whether you are earning in the form of interest or dividends, and if the earnings qualify for tax-exemption. Also note that there is no allowance for those who pay the additional rate of income tax.
Does it affect my ISA?
Earnings from an ISA – be it cash ISA, stocks and shares ISA or innovative finance ISA – do not count towards the personal savings allowance. So in theory you can benefit from earning tax-free interest in two ways:
- On any interest earned through your £20,000 annual ISA allowance, or through any old ISAs.
- Plus the £500-£1,000 of interest you can earn tax-free through the personal savings allowance.
However, the introduction of the personal savings allowance has had an impact on cash ISAs. Now that interest from any savings product – up to the stated limit – can be earned tax-free through the personal savings allowance, the popularity of the once-ubiquitous cash ISA appears to be waning. According to The Times, in the 2017/8 tax year, 697,000 fewer of these accounts were opened than in the previous year. The mostly low interest rates on offer, plus the tax advantages now offered by the personal savings allowance, help explain that change.
The personal savings allowance is giving consumers more choice in how they save their money to earn tax-free returns. It means you no longer have to look to a cash ISA to earn tax-free interest, and can shop around to find the best savings rates on the market.
But remember: only interest, not dividends, apply for the tax-free status. Still, that hasn’t stopped the UK as a whole from taking a turn towards the investment market. While cash ISAs have stagnated, the stocks-and-shares equivalent is booming. In 2017/18, there was a £6.38bn annual increase in money invested into these accounts, marking a 56% upsurge over the previous five years. As consumers are able to save more tax-free, they appear to be sharpening their investment appetites in turn.
Don’t forget, investment ISAs place your capital at risk, and it is possible you’ll get back less than you put in. Also, tax treatment depends on individual circumstances, and could be subject to change.