Five ways 45p extra rate taxpayers can avoid savings interest tax

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By Creative Media News

  • Extra-rate taxpayers face high savings interest tax
  • Use ISAs, pensions, and bonds strategically
  • Maximize allowances to minimize tax impact

Many extra-rate taxpayers face tax bills on their savings interest, possibly unknowingly.

HMRC expects to collect £10.37 billion in savings interest tax in the current fiscal year 2024-25.

It anticipates a stunning £6.8 billion from extra-rate taxpayers, who do not receive a Personal Savings Allowance, unlike basic-rate and higher-rate taxpayers.

This means that extra-rate taxpayers will pay 65 per cent of the total amount HMRC expects to earn in savings interest tax in the current tax year.

Unlike primary and higher-rate taxpayers, extra-rate taxpayers do not have a Personal Savings Allowance (PSA), so all interest earned on their savings is taxed at 45 per cent.

Because interest rates have risen so dramatically over the last two and a half years, while the personal allowance has been frozen, more extra rate taxpayers may face even higher tax burdens in the coming years.

According to Laith Khalaf, head of investment analysis at AJ Bell, “The Office for Budget Responsibility estimates that the freeze on the Personal Allowance will create 350,000 additional rate taxpayers over the next four years.”

Here are five things you may do if you have a substantial savings account as an extra-rate taxpayer and wish to recoup part of your money from the taxman.

  1. Maximize your cash. Isa

The prominent place to begin is Isas. Isas are a valuable instrument for savers to avoid tax since they allow you to save up to £20,000 each year tax-free.

Every April, savers receive a new £20,000 annual Isa allowance for the fiscal year.

That means you can save up to £20,000 in an Isa tax-free, with any interest earned on your savings exempt from taxation.

Isas are becoming more popular as interest rates rise and the Personal Savings Allowance is frozen.

According to recent Bank of England data, savers transferred £4.2 billion into tax-free accounts in May.

It comes only a month after savers contributed a record £12.3 billion to Isas in April. The May total is a record for the month since Isas began in their current form 25 years ago.

Between January 2023 and May 2024, £73.5 billion rushed into cash Isas as people sought to protect their hard-earned money from the taxman.

Today, ISAs provide appealing rates of 5% or higher, so there is no need to choose an ISA over other forms of accounts when the rates are comparable or greater.

An extra-rate taxpayer who invests £20,000 in the best savings account earning 5.02 per cent will earn around £1,004 in interest after a year.

An extra rate taxpayer would pay £451.80 in tax on this, receiving just £552.50 in interest; however, if the £20,000 were held in an Isa, they would pay no tax on the money.

  1. Max out premium bonds.

Premium Bonds are up next. NS&I accounts are the most popular savings product in the country, with around 22 million clients depositing money into Treasury-backed savings accounts.

Every month, Premium Bond holders are entered into a reward drawing.

Every £1 you invest in Premium Bonds earns you a unique Bond number and an equal chance of winning a monthly prize of between £25 and £1 million (there are two £1 million prizes each month).

There is no guarantee that you will win any reward in a particular month, but any winnings are tax-free.

Premium Bonds do not earn interest. Instead, a yearly prize fund rate supports a monthly prize draw for tax-free rewards.

The current odds of winning a prize are 21,000 to one, with the annual prize fund interest rate, which is not guaranteed, unlike a savings account or Isa, now at 4.4%.

Premium Bonds allow you to save a maximum of £50,000.

  1. Maximize your pension contributions.

Looking ahead, pension contributions can be a very effective strategy to reduce your overall income tax burden, not just the savings interest tax.

The annual allowance is the amount you can contribute to your pension each year to obtain tax savings.

Your earnings determine the amount you can pay. Everyone has a yearly pension allowance of £60,000, or 100% of their relevant earnings if less.

You can contribute to your pension more than your annual allowance, but any tax relief received must be repaid through an annual allowance charge.

April Leeson of The Private Office stated, “As an additional rate taxpayer, you may be able to carry forward your unused annual allowance, and thus tax relief, from up to three years prior, allowing you to pay in more than the £60,000 annual allowance.”

‘If a person had £100,000 in savings and could contribute into their pension, they would receive £25,000 in basic rate tax relief, for a total contribution of £125,000.’

The money is subsequently placed in your pension wrapper and can only be accessed once you reach the age of 55 or 57 beginning in April 2028. The funds within your pension will grow tax-free.

The tax payable on anything beyond your 25% tax-free lump sum will be determined by your marginal income tax rate at the time and your withdrawal or income rate.

By contributing to a pension, you can also claim higher and additional rate tax relief on your contribution amount each year through your self-assessment, albeit whether you are required to do so depends on the type of scheme you are in.

If you pay enough, you can begin to recover your lost ‘tapered’ personal allowance of £12,570, allowing you to benefit from this tax-free sum as well.

Depending on your earnings, your yearly limit may be less than £60,000, with the whole tapering allowance set at £10,000.

  1. Make the Most of Other Allowances

If you have already used up your Isa, Premium Bonds, and pension contributions, consider using other allowances to protect more of your funds from savings interest tax if you are an extra-rate taxpayer.

If you have investments, one method to reduce your savings tax burden is to use up your dividend allowance.

The dividend allowance is the maximum amount of dividends you can earn before being taxed. For the current tax year, it has been reduced from £1000 to £500.

A saver with £100,000 invested in an unwrapped investment would be taxed on dividends, income or interest, and capital gains.

Capital growth may outpace payouts or vice versa, depending on the type of investment or plan.

The first £500 in dividends paid each tax year would be exempt from dividend tax. For extra-rate taxpayers, dividends over £500 would be taxed at 39.95%.

Leeson stated that if the £100,000 were worth £103,000 at the end of the tax year, there would be no need to pay capital gains tax. If it’s worth £110,000 after a year, you may make £10,000 in profit.

‘Then £3,000 is complimentary, while the remaining £7000 profit is taxed at 20%. That equates to a net profit of £8,600 after tax.

“Compared to if the saver left the funds in cash and somehow made £10,000 interest, this would be taxed (with no Personal Savings Allowance available) at 45 per cent (£4,500), so £5,500 net interest earned (vs. £8,600 when capital gains applied).”

  1. Consider investment bonds.

Additional rate taxpayers can use investment bonds to offset their savings tax payment.

They seek to increase an investor’s money over time. An investor typically sends a significant sum to a life insurance company to invest in you, typically in various funds.

There are two types of investment bonds: onshore and offshore. The most significant distinction is in their tax treatment.

Onshore bonds are subject to UK corporation tax, which your provider offsets, but offshore bonds are issued in tax havens outside of the UK, such as the Isle of Man, Dublin, Luxembourg, or the Channel Islands, where the funds are subject to little or no tax.

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One of the primary benefits of investment bonds is a law that allows savers and investors to withdraw up to 5% of their investment in a bond each policy year without paying an immediate tax penalty until the entire policy is removed.

Savers do not pay tax on bond gains unless a chargeable event occurs. A chargeable event can be death in which benefits are payable or the policy attaining maturity.

This tax ‘deferral’ is one characteristic that distinguishes investment bonds from other types of investments.

According to Leeson, both onshore and offshore investment bonds have distinct tax treatment but can result in significant income tax savings, mainly when extra-rate taxpayers stop earning so much (and so become basic-rate taxpayers).

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