Recent months have seen people rushing to take advantage of record savings rates, boosted by several consecutive increases in the Bank of England’s base rate.

But a bigger savings pot means that you may push past your tax-free allowances, and indeed, new analysis from Paragon Bank shows that the number of savings accounts with balances large enough to incur tax on interest has tripled over the past year.

If you’ve been hit by tax on your savings returns, or you’re looking to get started saving, it’s useful to understand how you may be able to use Individual Savings Accounts (ISAs) to potentially decrease the amount of tax you have to pay.

Do I have to pay tax on my savings?

Everyone has a basic Personal Allowance, which is the amount you can earn in income each year before paying tax. This is set at £12,570 in the current tax year. However, most people who are working or supporting themselves through a pension will exceed their Personal Allowance through their salary or pension drawdown, so your Personal Allowance will likely only cover your savings if they are your sole form of income.

Most people also have what is known as a Personal Savings Allowance, which is different to a Personal Allowance, and applies to your savings and investments exclusively. This lets you earn a certain amount of income from your savings and investments without having to pay tax on it – once your savings income exceeds your allowance in a tax year, you pay tax on the amount over the threshold.

Basic rate taxpayers have a yearly Personal Savings Allowance of £1,000, while higher rate taxpayers get a £500 Allowance. Additional rate taxpayers do not receive a Personal Savings Allowance.

If you exceed your Personal Savings Allowance, then you’ll pay income tax on any returns your savings make in excess of your Allowance. If your returns are big enough, they may even push you into a higher tax bracket when combined with your other income, so it’s well worth keeping a close eye on all of your sources of income and the amount of tax you’re paying on them.

How can I protect my savings from tax?

One way that you may be able to make significant savings returns without having to pay tax on them is to open an Individual Savings Account (ISA).

An ISA is essentially a tax-efficient “wrapper” for your savings and investments. Any returns you generate from savings or investments in an ISA structure aren’t subject to income tax or capital gains tax. So, if there is an ISA available offering a similar rate to one of your savings accounts, and your returns are likely to exceed your Personal Savings Allowance, you may be able to get more bang for your buck by transferring your savings into it.

However, you should be aware that you have an annual allowance that limits the amount you can deposit into your ISAs each tax year. This is currently set at £20,000 in the 2023/24 and the 2024/25 tax years.

If you’re considering getting an ISA and have more than £20,000 to save then now would be a great time to go for it, as you will be able to use your current allowance and then have a fresh allowance to use in April when the new tax year begins. In other words, you could put away up to £40,000 in the next couple of months and not be hit with any tax bills on the returns.

Don’t assume that you’re unlikely to breach your Personal Savings Allowance. According to analysis from Paragon, last year saw a 246% increase in adult non-ISA accounts breaching the £1,000 mark in savings interest, meaning that many people will have only recently started paying tax on their savings for the first time. Getting to grips with ISAs and their advantages for tax benefits can therefore be hugely advantageous.

In fact, with the tax savings from an ISA factored in, you could potentially stand to earn more after tax even if the ISA pays a lower rate than your usual savings account.

For example, say you have a regular savings account paying 3.5% interest and an ISA paying 3.3% interest. Let’s imagine that you have £20,000 in both, and ignore other allowances for the time being.

Assuming the interest rates held and paid out after a year, your regular savings account would generate £700 before tax, and your ISA would generate £660. However, after deducting the basic rate of income tax (20%) from your £700 return (£140), you would be left with just £560, making the ISA (which is not taxed) more profitable.

Of course, this is a very simplified example, and ignores your Personal Savings Allowance. In practice, you could try to take advantage of both your Personal Savings Allowance and your ISA allowance in conjunction to optimise your savings.

Learn more about ISAs in our article Everything you need to know about ISAs or visit our ISAs explained section to learn more about the different types of ISA.

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