Five ways you could be hit with a hidden tax bill – and how to avoid it

SAVERS could be hit with a tax bill after being caught out with where they put their cash.

The interest rates on cash savings accounts have risen steeply over the past few years, dragging millions of people into paying tax on their savings income.

The number of people paying tax on savings income in the 2022/23 tax year almost doubled to 1.77million from the 970,000 people who did so in 2021/2022.

Savers typically breach the personal allowance with just over £16,500 in savings, according to wealth firm The Private Office.

There are several ways to save money without having to pay tax, but many people are being caught out – and they may not even realise why.

Laura Suter, director of personal finance at AJ Bell, explained: “While lots of people are using ISAs to protect their money from tax or organising their savings to cut their tax bill, there are some sneaky tax traps that will catch some savers out without even realising it.”

“For example, the personal savings allowance protects lots of people from paying tax on their savings, as it means basic-rate taxpayers can earn £1,000 in savings income before they pay tax on it, while higher-rate taxpayers have a £500 allowance.

“But lots of people will breach this limit this year – maybe without knowing.” 

Savings tax traps to avoid

Ms Suter said there are five lesser known “traps” that many savers could get caught out on and should be aware of.

Trap 1: Fixed rate accounts 

Fixed-rate savings accounts are in at the moment, as interest rates are high and savers have been able to lock into a good deal.

But according to Ms Suter, these accounts could leave you with a “tax headache” in future.

“Lots of people are picking fixed-rate savings accounts at the moment, locking their money up for one, two, three or even five years to get a guaranteed interest rate,” she said.

“But you are taxed on the interest on your savings when it is accessible by you, so if you pick a fixed-rate savings account that pays out all the interest at maturity, for tax purposes all of that interest will be counted in one tax year.

“This means that the interest from just one account could take you over your Personal Savings Allowance on its own.”

She explained that this is particularly a problem for longer-term fixed accounts, as you may have accumulated three or even five years of interest which will be paid out in one go.

For example, £7,500 in savings in the current top three-year fixed-rate account paying 4.51% would pay out £1,061 interest at maturity if it compounded annually, taking a basic-rate taxpayer over their Personal Savings Allowance for that year.

“To get around this trap you could opt for an account where the interest is paid out monthly or annually, meaning it is spread across different tax years. Or you can opt for a fixed-term ISA savings account, where you won’t pay any tax on the interest,” Ms Suter said.

Trap 2: Tax on your child’s savings 

Money gifted to your children is also not exempt from generating a tax bill, which many parents may not realise.

A little-known rule means you may have to pay tax on any interest earned on your children’s savings.

“This sneaky tax rule means that once a child earns £100 or more in interest on money that has been gifted by parents, it is taxed as though it is the parent’s money,” Ms Suter explained.

“When interest rates were at historic lows, it was not much of a concern. But the top children’s easy-access account pays 5.25%*, which means that once you have more than £1,900 saved, you will hit that £100 limit.”

If you reach £100, then any interest is counted as though it is the parents’ and will eat into their own personal savings allowance. 

“This won’t be a problem if you haven’t earned much taxable interest yourself, but if you’re near (or already over) your Personal Savings Allowance you’ll be hit with unexepected tax,” Ms Suter explained.

This rule only applies to money gifted by parents, not by money given by other family or friends. And the limit is also per parent.  

One way around this is to use a Junior ISA account to pay your kids money, as any interest is protected from tax. But be aware they won’t be able to access the money until they’re 18.

Trap 3: Tipped into the next tax bracket 

The Personal Savings Allowance of £1,000 is halved if you become a higher rate tax payer.

So if you earn more than £50,270 (even by £1) you’ll become a higher-rate taxpayer and see your Personal Savings Allowance cut from £1,000 to £500.

“One thing lots of people aren’t aware of is that savings interest counts towards this limit, so if you have a £50,000 annual salary you would be in the basic-rate of income tax, pay tax at 20% and have a £1,000 Personal Savings Allowance,” Ms Suter said.

“However, if you also had £1,000 in savings income, you would tip into the higher-rate tax bracket and see your Personal Savings Allowance cut to £500.”

You can get around paying tax on your interest earned by saving into an ISA instead of a regular savings account, as these are tax-free.

You could also pay the money into your pension instead, as this reduces your income – potentially bringing you back into a lower tax band. Money paid into pensions is also tax-free.

Trap 4: Joint savings account 

Having a joint savings account could also uwittingly land you with a tax bill to pay.

Lots of people may not realise that having savings together means the interest is split 50/50 between the two account holders.

For example, if a joint savings account that generated £1,000 of interest each year, it would be split so that each partner has £500 interest to count towards their Personal Savings Allowance.  

“If one half of a couple is a lower earner, and so in a lower tax bracket, it could make sense to move the savings into an account in their name, as any interest that’s taxable will be paid at a lower rate,” Ms Suter explained.

“For example, a higher-rate taxpayer who had £1,000 of taxable interest would pay £400 in tax on the money, while a basic-rate taxpayer would only pay £200 in tax.”

“Even if both partners are in the same bracket, if one half hasn’t exhausted their Personal Savings Allowance you could move savings into their name to maximise their tax-free amounts.” 

Trap 5: Not realising it’s not just savings interest that counts 

Even those who know about the Personal Savings Allowance may not realise it’s not just savings interest that counts towards this.

For example, interest from investments may count as interest and will count towards your allowance.

“With a fund, if the fund invests more than 60% in bonds and cash, then payments from the fund are classed as interest rather than as dividends,” Ms Suter said.

“Your investment platform or provider will usually send you a tax statement each year to show you how much you’ve made in interest in that tax year, to help with your calculations.”

The easiest way to avoid being taxed on interest from investments is by using a stocks and shares ISA.

We recently revealed how saving just £10 a month into a stocks and shares ISA could grow you a £32,000 savings pot long-term.