How the personal savings allowance works

Savers may be benefiting from higher interest rates on savings accounts but that could also leave some with an unexpected tax bill.

Savvy savers can currently get around 5% in the "best paying easy-access accounts", said NerdWallet.

But while the savings market has been "sweetened" by higher interest rates, said The Times Money Mentor, after more than a decade of "rock bottom" deals, those with "bigger cash piles" could face tax implications.

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This is because the interest rates on offer could take savers above the personal savings allowance (PSA).

What is the personal savings allowance?

The personal savings allowance was launched by the then chancellor George Osborne in April 2016.

It gives basic rate taxpayers a £1,000 allowance that can be earned from cash savings accounts tax-free, dropping to £500 for higher rate taxpayers.

HMRC declared at the time of the PSA introduction that around 85% of savers would no longer pay tax on their savings, said This Is Money, but the PSA "hasn't budged" since and has failed to move in line with the cost of living.

This could put savers in a position they "might not have anticipated in recent years" – paying tax on savings interest.

What happens if you go above the PSA?

A consequence of savings rates being "so good at the moment", said the Daily Express, is that you could have as little as £10,000 in savings and need to pay tax on it.

More than six million accounts are now in line to breach the PSA, according to Shawbrook Bank research cited by The Telegraph. Once savings interest exceeds the allowance, savers "must start paying income tax on it at their normal rate".

Banks tell HMRC how much interest they have paid you, said The Times Money Mentor, "so the taxman will know how much you have to pay".

The way you pay tax on your savings interest, said Money.co.uk, depends "on how you work". The self-employed have to declare interest earned on savings through their self- assessment tax return.

Things are "slightly different" if you are employed and taxed under PAYE. HMRC will change your tax code "so you pay the tax automatically".

How to avoid going above the PSA

It may be worth considering a cash ISA, said Rest Less, as you can save up to £20,000 each year and "won’t have to pay any tax on your returns". Cash ISA rates have been "pretty poor" in the past, but they are catching up with standard savings accounts.

You could also put more money into your pension, said MoneyWeek. There is the "downside of not being able to access it until later in your life" but you also get tax relief on contributions.

Another option is Premium Bonds, said This Is Money, as "any money won from prizes is tax-free".