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Better saving rates are here – but they come with a tax threat

Piggy bank
Piggy bank

For the past decade savers have seen their money languishing in poor paying accounts due to low interest rates. But as the Bank of England pushes up its rate to tackle soaring inflation, savers’ fortunes are changing.

The top easy access savings account now pays 2.1pc, up from 0.75pc in December, according to analyst ­Savings Champion.

Experts expect the rising Bank Rate, which hit 2.25pc this week, to be reflected in the top accounts, so savers can make the most of their money by switching to those accounts.

Many of the country’s biggest banks have been slow to pass on interest rate rises, with the average easy access rate at 0.79pc. But the picture is still rosier than it was in December, when returns were at an average of 0.15pc.

The tax trap

The spike in rates is welcome news for savers, but they could soon be liable for income tax. Higher-rate taxpayers can earn £500 of interest from their savings before having to pay tax. Basic-rate taxpayers can earn £1,000.

Last December, higher rate taxpayers would have needed more than £66,666 in the top easy access account, which paid 0.75pc, to breach their personal savings allowance, according to Savings Champion.

Now, someone with more than £23,800 in the best paying account at 2.1pc will be susceptible to a tax bill, according to broker AJ Bell.

If the Bank Rate reaches market forecasts of 3.75pc by the end of 2022, the threshold will likely drop to £13,338. In 2023, when the Bank Rate is expected to peak at 4.5pc, savers with more than £11,100 would have to pay tax.

Laura Suter, of AJ Bell, said that because income tax allowances have been frozen, more people are being pushed into the next tax bracket and are seeing their personal savings allowance chopped in half.

Cash is a boom

Savers can get around this tax trap by putting as much as £20,000 a year into an Isa. The tax-free accounts are now expected to become more popular in the coming months as rates rise.

Ms Suter said: “We’re going to see a boom in use this tax year, as savers try to shelter their money from the ­taxman.”

Sarah Coles, of broker Hargreaves Lansdown, said some savers may be wary of cash Isas because they tend to pay slightly lower rates than their savings account equivalents.

The top easy access cash Isa pays 1.85pc, which is less than the top easy access rate of 2.1pc, according to Savings Champion. Some will do calculations depending on their circumstances and only switch a chunk of their savings into a cash Isa when they breach the tax threshold.

“The break-even point depends on the difference between the rates at any given time, the rate of tax you pay, and the amount of money you have,” Ms Coles said.

Fixed-rate threat

Another pitfall for savers is longer term fixed-rate deals. They offer the highest savings rates on the market, but you could lose thousands of pounds by opting for these deals now instead of waiting until interest rates rise even further, according to Hargreaves Lansdown. The broker looked at what would happen to savings pots over six years for those who opted for a five-year deal now or in the future.

Savers who put £30,000 into the best five-year fixed deal now, which pays 3.75pc, and then put their money in a one-year deal – at which point interest rates could fall back to the levels they are at now, with the best deal at 3.47pc – would end up with £37,451.

Putting the same amount into the best one-year deal now and then taking out a five-year deal – at which point the best rate would be 6pc – would result in a total of £41,540.

The calculations assume the Bank Rate will reach 3.75pc by the end of next year and 4.5pc in 2023, before falling back down to roughly where it is now in five years’ time.

Ms Coles warned that predicting rates is notoriously difficult, so a sensible solution for many people is to take out shorter fixed deals.

Those already locked into longer term fixed deals could earn more by breaking out of them and securing a new one with a better interest rate.

Ms Suter said some banks will let savers take their money out early, but a common penalty is 90 days’ interest.