As interest rates rise, here’s why using your ISA allowance is more important than ever

Following the global financial crisis, the last decade has been a challenging and often frustrating time for savers.

Low interest rates have been highly beneficial for borrowers but, conversely, if you’re a saver you will have seen very modest returns on your cash savings.

However, since the latter part of 2021, interest rates have risen significantly. As a result, many savings providers have offered improved interest rates on their products and now, your cash savings may be enjoying much better returns.

It’s likely that, when interest rates were low, you weren’t concerned with paying tax on the interest you earned. In fact, you may not have been earning enough for it to be a problem.

However, as interest rates rise, it is increasingly likely that your returns will be liable for Income Tax – especially if you hold a significant amount of cash savings.

Indeed, a report by FTAdviser suggests that almost 1.8 million savers in the UK are now paying tax on interest earned from banks and building societies.

Unsurprisingly, this is leading to many investors looking to ISAs as a tax-free alternative. In fact, FTAdviser revealed £9 billion was invested in ISAs in April 2023 alone.

So, read on to find out more about how rising interest rates means you’re more likely to be liable for tax, and how making the most of your ISA allowance is as important as ever.

Interest rates have risen in the last 2 years

In the last 18 months, the UK inflation rate has not been far from the headlines.

Latest figures from the Office for National Statistics (ONS) show that the UK’s inflation rate stood at 7.9% in June 2023. Back in March 2021, the rate was just 0.7%.

There are many contributing factors to the increased inflation rate, with the primary one being the soaring cost of energy. Already in huge demand following the start of the Covid pandemic, gas and oil reserves were put under further pressure by Russia’s invasion of Ukraine.

In an attempt to control inflation, the BoE has increased interest rates 14 times in the last two years. As of 3 August 2023, the base rate stood at 5.25%. The BoE believes that raising the base rate encourages saving, tempers rising inflation, and can help with the cost of living crisis.

As a result of rising interest rates, you may exceed the Personal Savings Allowance

While rising interest rates are good opportunities for savers, you will need to consider the tax you might pay if your interest exceeds the Personal Savings Allowance (PSA).

As the PSA limits how much interest you can receive each year without you incurring an Income Tax bill, it’s important to be aware of just how cash accounts can be affected by the BoE’s base rate increases.

The amount of PSA will depend on the type of taxpayer you are:

  • Basic-rate taxpayers (paying 20%) can earn £1,000 in tax-free interest each year
  • Higher-rate taxpayers (paying 40%) can earn £500 in tax-free interest each year
  • Additional-rate taxpayers (45%) do not have a PSA.

For example, if your £50,000 in cash savings benefits from a 4% interest rate for an entire year, you would earn around £2,000 in interest. If you’re a higher-rate taxpayer, £1,500 of this would be subject to Income Tax.

Consider that, as of 3 August 2023, Moneyfacts reports that the best interest rate on an easy access savings account is 4.63%. If you’re a higher-rate taxpayer, you’d only need to hold around £10,800 for a year in that account to earn enough interest that you’d exceed your PSA.

If you are employed and exceed your PSA, HMRC will typically change your tax code to account for the Income Tax you owe. If you are an additional-rate taxpayer or you are self-employed, you’ll need to declare the interest earned on your cash savings when you self-assess.

If you are worried about how rising interest rates could push you past your PSA, it’s important to look at all the options available to you. With that in mind, an ISA could be a way of shielding your wealth from tax.

Unlike savings accounts, Cash ISAs are not subject to the PSA

While Cash ISAs work similarly to savings accounts in many ways, interest earned on a Cash ISA is paid free of Income Tax, meaning it doesn’t count towards your PSA.

If you currently have money in an easy access cash savings account and believe the interest rate rises might push you above the PSA, placing your cash into an ISA could be a potential option to consider.

You can contribute up to £20,000 to an ISA in the 2023/24 tax year. And, as it’s an individual allowance, couples can contribute up to £40,000 a year to tax-efficient savings.

If you are considering a longer investing horizon, a Stocks and Shares ISA could also offer the potential for tax-efficient growth.

All returns from a Stocks and Shares ISA are paid free of Income Tax, Dividend Tax, and Capital Gains Tax. Consequently, they can be an effective way to shield your wealth from tax in the medium to long term.

Remember that the money in a Stocks and Shares ISA will be invested, and so the value can go down as well as up and you may not get back the full amount you invested.

You could avoid tax and help your children financially in the process

If you have maximised your ISA contributions and you have children under the age of 18, you could also consider putting money aside for them tax-efficiently in the form of a Junior ISA (JISA).

Working similarly to adult Cash ISAs, these accounts are tax-efficient and won’t be affected by your PSA.

Available as either cash or stocks and shares options, a JISA will enable you to financially help out your child or grandchild in the future while, at the same time, shielding your cash from tax.

Working closely with a financial planner can help

If you’re worried about paying tax on your savings, and you’d like to explore how the PSA might affect you, please get in touch.

Working with a financial planner will help you to effectively plan for the future and understand the most effective ways of protecting your wealth from tax.

Email or call us on 01454 416653.

Please note

Investments carry risk. The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.

This article is for information only. Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.

This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.

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