Whether or not you pay tax on your savings depends on your total income, how much you save and how much interest you earn within a tax year. Tax on savings interest is calculated on the amount of interest earned. For most people, you can earn up to £1,000 in interest without paying any tax.

This mostly depends on how much Income Tax you pay. If you are a basic-rate taxpayer (20%) then you can earn up to £1,000 in interest without paying tax. If you are a higher-rate taxpayer (40%), this reduces to £500 of tax-free interest and if you’re an additional-rate taxpayer (45%), you pay tax on all interest earned from savings.

If you’re unsure of which rate of tax you currently pay, it’s a good idea to check your income level and see where you stand. The current Income Tax thresholds are as follows:

Your Personal Savings Allowance (PSA) is the allowance that you can save as an individual without paying tax. This allowance applies to anything where your account earns interest such as savings accounts, gilts, bonds, credit union accounts or building societies within a tax year.

This is an additional tax-free allowance for low income earners. The starting savings rate applies to anyone earning less than £17,570 and entitles them to earn interest up to £5,000 tax-free on top of their Personal Savings Allowance.

How much additional tax-free interest you can save under the starting rate for savings depends on how far below the £17,570 income threshold you sit. For example, if your income is under £12,570, you are entitled to the full additional £5,000 tax-free interest. You lose £1 of the £5,000 for every £1 you earn over the £12,570 personal allowance.

This is mostly based on your taxable income, which includes all your earnings such as wages, pensions, and any other sources of income. How your PSA is calculated and whether or not you qualify for the starting rate for savings is quite complex. The Government’s website has a detailed breakdown here.

Most people won’t exceed their tax-free savings allowance within a tax year. It’s important to have an idea of what will take you over your tax-free threshold, and the amount of tax you may have to pay.

As an example, someone with an annual income of £28,000 would have a Personal Savings Allowance of £1,000. If they had one savings account with a 4.75% interest rate, they could comfortably save £21,000 within the tax year without paying tax on the £987 interest they earned.

If you go over your Personal Savings Allowance, the taxes due also depends on your Income Tax rate. There are three rates you will pay tax on savings over your PSA. These are as follows:

• Income between £17,570 and £50,270: 20%
• Income between £50,271 and £125,140: 40%
• Income exceeds £125,140: 45% 

If you find that your interest earnings exceed your tax-free allowance, you will need to declare this on your tax return. The amount over the allowance will be taxed at your Income Tax rate (as above). Keep records of your interest earnings throughout the year to make this process easier.

An ISA allowance is different to a Personal Savings Allowance. Instead of being calculated based on interest earned, an ISA allowance lets you save up to £20,000 a year tax-free.

An ISA allowance is completely separate from your PSA as it is effectively ring-fenced to protect it from tax. This allows you to save a greater sum while making the most of your interest. To understand more on how the ISA allowance works, read our ISA allowance explained guide here.

While both allowances provide tax benefits, they serve different purposes. The ISA allowance is a more flexible option for long-term savings as it allows you to invest in a variety of products, including cash ISAs, stocks and shares ISAs, and innovative finance ISAs. This means you can choose the best option that suits your financial goals.

On the other hand, the PSA is more straightforward and applies to interest earned on traditional savings accounts. If you have a significant amount of savings, using both the ISA allowance and the PSA can make the most of your tax-free income.

To make the most of your savings while minimising tax, consider the following: 

• Use ISAs: Individual Savings Accounts (ISAs) allow you to save up to a certain limit each tax year without paying tax on the interest earned. For the 2023/2024 tax year, the limit is £20,000. This means you can save in cash ISAs, stocks and shares ISAs, or a combination of both.
• Shop around for accounts: Different lenders offer varying interest rates. By comparing rates, you can find accounts that provide the best returns on your savings.
• Consider joint accounts: If you have a partner or spouse, consider opening a joint savings account. This way, both of you can benefit from separate Personal Savings Allowances, effectively doubling your tax-free interest earnings.
• Stay informed: Tax rules can change, so it’s crucial to stay updated on any changes that may affect your savings. Regularly reviewing your financial situation can help you make informed decisions.