How to pay no tax on your savings (but there’s a catch)

Savings rates are the highest they’ve been in years – good news on the face of it, but if you’ve got a lump sum to save then you could easily end up with extra tax to pay.

Yet, if you’re married or in a civil partnership, a bit of extra planning could mean you’ll pay 0pc tax on up to £6,000 of savings income. This excludes dividends, but does include interest earned from banks and building societies.

Here, Telegraph Money explains how to increase your tax-free savings allowance, and offers other tips on how to reduce your tax bill.

Who can access zero per cent tax

The zero tax rate on savings interest is intended as a savings incentive for those on lower incomes, but it can benefit well-off households, too – as long as one spouse earns less than £17,570. The 0pc tax break is granted at an individual level, irrespective of the higher-earning spouse’s income.

For example, younger families will often have one parent working full-time with the other looking after the children but with a part-time job. Alternatively, among couples in later life, one spouse may have retired on a good occupational pension while the other spouse receives a lower pension. 

Those with a lower income are eligible for the “starting rate for savings”. This is up to £5,000 of tax-free savings interest. Those who earn less than the personal allowance (currently set at £12,570 until 2027-28) get the full benefit, but it decreases pound-for-pound when you earn above and beyond the allowance. 

Therefore, by the time you earn £17,571, all of the extra tax-free allowance will be used up.

However, you’ll get the standard personal savings allowance as well. For basic-rate (20pc) taxpayers this is worth £1,000, reducing to £500 for those who pay higher-rate (40pc) tax. If you’re an additional-rate taxpayer, then all savings interest is taxable.

In cases where one spouse earns, say, £12,000 and the other earns £50,000, as a couple they could potentially earn up to £7,000 before paying tax, were they to use the full allowances available to them – as long as the lion’s share of savings were held by the spouse with a lower income.

How does savings income get taxed?

When working out how much you might be taxed on your savings interest, you’ll need to factor in your other forms of income. This could be from sources such as earnings from employment, rental income or money received from your state pension.

Things like savings interest are then layered on top, and – if you’re unfortunate – can push you into a higher tax bracket. This is why it makes sense for couples to organise their savings to sit with whichever spouse has the least tax liability.

Suppose this year you had earnings or pension income of £12,570 and savings income of £3,000, but nothing else. The first £1,000 of savings income is covered by your savings allowance. The remaining £2,000 will be taxed, but at a special rate of 0pc.

To make it more complicated, suppose your income this tax year, other than savings income, is £16,000. Since this is £3,430 more than the personal allowance, it reduces the £5,000 savings band by the same amount. It therefore leaves £1,570 of the savings band available. Now, suppose your savings income is £3,000. The first £1,000 is covered by the savings allowance, the next £1,570 is taxed at 0pc leaving £430 to be taxed at the 20pc basic rate, or £86.

Income is taxed in a specific order, which gives rise to more tax planning opportunities. 

First non-savings income (earnings, pensions and rent) is taxed, then savings income (interest) and then dividends – payouts from companies to shareholders. 

This means that unused personal allowance can be used to offset other forms of income. For instance, if you earn £12,000 a year, there is £570 available to offset against savings interest. 

What counts as savings income?

It’s not just interest earned from bank and building society accounts that counts as savings income – interest (but not dividends) paid from unit trusts, government or corporate bonds and “open ended” investment companies (Oeics) are also included.

Savings income does not, however, include income from Isas, as these are tax-free.

Rather surprisingly, dividends received from companies are not treated as savings income either, and are instead taxed separately under altogether different rules.

How much could you save tax-free?

With the official Bank Rate at the highest since 2008, savings rates are the most generous they have been in years. As a result, increasing numbers of savers are at risk of having to pay tax on their returns. 

If you qualify for the full starting rate for savings and have a potential £6,000 of tax-free savings interest at your disposal, this could potentially shield a lump sum of £118,000 from tax if you were to save it in the top-rate one-year fixed-term bond from Al Rayan Bank, paying 4.95pc. 

If you earn more than £17,570 but less than £50,270, the starting rate of 40pc income tax, your savings interest will remain tax-free up to £1,000. If you save with the same bond, a balance of around £19,000 wouldn’t exceed the personal savings threshold.

If you’re a higher-rate taxpayer, you can only earn up to £500 in savings interest before paying tax. With interest at 4.95pc, this means you’d only be able to save up to £9,800 without being in danger of a tax bill. 

Higher earners and those with larger savings sums should probably look to other methods for saving tax.

Other ways to reduce your tax bill

Save with an Isa

Perhaps the most obvious way to keep your savings and investment growth tax-free is by holding your money in an Isa. But if you’ve got a lot to save, the £20,000 Isa allowance means it could take years to move your cash over to a tax-free account. 

Use the marriage allowance

This one won’t shield your savings, but can reduce your household’s tax bill. Where one spouse earns less than the personal allowance and the other is a basic-rate taxpayer, the lower-earner can effectively transfer 10pc of their personal allowance to their partner. This increases the higher-earner’s tax-free income from £12,570 to £13,830, potentially saving £250 in income tax each year.