Understanding the Impact of Rising Interest Rates on Your Savings

From mortgage holders to loan seekers, rising interest rates in the UK can stir up a sense of trepidation. Yet those with money tucked away in savings may find themselves in a position to cheer. Recent changes to the interest-rate landscape mean that those of us with money in the bank could be seeing greater returns on our investments. From August 2021 through to September 2023, rates have steadily climbed, peaking at a very appealing 5.75% per year. But along with higher returns, comes a new consideration: tax, and just how much of your increased income will find its way into the government’s coffers. Cumbria Crack’s financial expert looked at the implications.

The Tale of Rising Interest Rates: A Mixed Bag

In today’s highly-volatile financial climate, we find ourselves noticing the little shifts in the economy more than we used to. The UK’s interest rates have been inching up since August 2021, and while borrowers might have winced at this trend, savers are keen to welcome the increasing returns on their stashed cash.

Traditional saving accounts, such as fixed-term deposits and regular savings accounts, respond well to rate hikes. Through August 2021, the best one could hope for was a yearly return of 1.7 per cent on a five-year fixed-rate bond. Yet in September 2023, rates reached a far more enticing 5.75 per cent per year. The numbers are good news for savers, but the new bounty leads to a question about taxation.

Tax Requirements and Savings Allowances: The Nitty-Gritty

Imagine you had £55,000 in a five-year fixed rate bond. In August 2021, at 1.7 per cent, you’d earn £935 in interest. By September 2023, that same sum at 5.75 per cent would amount to £3,162.50 in interest. Your interest has grown, but so has the attention from HM Revenue and Customs (HMRC).

It’s crucial that you’re aware of how much interest you’re earning, and whether it bumps you up over the taxable limits set by the HMRC. The good news is that there are allowances in place that enable some savers to earn tax-free interest. The Personal Savings Allowance permits basic rate taxpayers to earn up to £1,000 interest without paying tax, and higher-rate taxpayers can make up to £500.

However, additional-rate taxpayers miss out on this allowance. In the scenario above, an additional-rate taxpayer would have owed no tax on the interest earned in August 2021. Yet, when September 2023 rolls around, they’d owe tax on £2,162.50 of their income.

The Unavoidable – Paying Your Due Tax

It’s a harsh reality that, as our interest earnings grow, so too might our tax obligations. Once you cross the threshold of the tax-free allowance, you’re obliged to complete a self-assessment tax return. These forms require you to detail your savings income, including interest from banks, building societies and other financial products.

The tax you owe will hinge on your overall income and tax banding. Basic rate taxpayers may find themselves hit with a 20% rate on their savings income, while higher and additional rate taxpayers could see rates of 40% to 45%.

Staying within legal bounds is essential. The line between tax avoidance (legally minimising your tax obligation) and tax evasion (illegal tax dodging) is the “thickness of a prison wall”, to quote former Chancellor Denis Healey.

Tax-Efficient Alternatives – A Glimpse at ISAs and Investment Funds

The good news is that there are completely legal routes to optimising your savings while minimising your tax payments. Individual Savings Accounts (ISAs) are a good place to start. These accounts let you save or invest up to £20,000 per tax year, with nary a penny paid on the interest earned.

ISAs come in many shapes and sizes, from Cash ISAs and Stocks and Shares ISAs to Innovative Finance ISAs. Each has its benefits, and choosing the right one could lead to a significant reduction in tax payments. Investment funds are another avenue worth exploring; here, allowances such as Capital Gains Tax can be used to chop down the tax bill.

Keep an Eye on Dividends: New Allowance Changes

Finally, it’s worth noting that changes have also been made to the dividend allowance. Pre-April 2018, individuals could pocket up to £5,000 in dividends without paying tax. This was cut to £2,000 from April 2018, and was further trimmed down to £1,000 for 2023/2024. Keeping up-to-date with these changes is essential, whether you currently invest in dividend-paying stocks, or plan to in the future.

So, while the rise in interest rates may boost the income from your savings, keep a close eye on your tax responsibilities. And perhaps most importantly, don’t run afoul of the taxman – the consequences might not be worth the risk! It’s always best to consult a tax professional or get in touch with HMRC