Savers urged to avoid 5 ‘sneaky’ tax traps as two million face shock HMRC bill

As savings rates rise four times as many basic rate taxpayers now pay income tax on their deposits than just three years ago, according to AJ Bell. Many wrongly assume they are protected by the Personal Savings Allowance (PSA), which allows basic rate 20% taxpayers to earn £1,000 in tax-free interest, falling to £500 for 40% taxpayers.

But Laura Suter, director of personal finance at AJ Bell, warned: “As savings rates rise, lots of people will breach the PSA this year, maybe without knowing.”

A basic rate taxpayer getting 5% on their savings will hit the PSA with just £20,000 of deposits, or just £10,000 for a 40% taxpayer. Suter warns of five more savings traps to avoid.

1. Getting pushed into a higher tax bracket. Income tax thresholds will remain frozen until 2028 and this will push more above their PSA.

You only have to earn a penny in income over the £50,270 higher rate threshold to see your PSA cut from £1,000 to £500.

Any interest above £500 will then be taxed at 40% and it gets worse, Suter said. “Earn more than £125,140 and you’ll become a 45% additional-rate taxpayer, where your PSA drops to nothing so every penny is taxed at 45%.”

The easiest way round this is to save inside a tax-free cash Isa. Alternatively, pay more into a pension. This may reduce your income so that you fall back into a lower tax bracket.

Suter said: “If your partner pays tax at a lower rate or hasn’t used up their PSA, consider switching savings into their name.”

2. Fixed-rate bond shock. Many savers are locking their money away for up to five years to get a guaranteed return but Suter warned: “This could leave them with a tax headache in the future.”

You are taxed on interest when it becomes accessible, so if your fixed-rate account pays out all the interest at maturity, it could easily push you over the PSA.

This is a particular problem for longer-term fixed accounts, Suter said. “For example, £7,500 in a three-year fixed-rate savings bond paying 4.51% would give you £1,061 at maturity if compounded annually. This would tip a basic-rate taxpayer over their PSA for that year.”

To avoid this, opt for an account that pays interest monthly or annually. Alternatively, take out a fixed-term cash Isa. Rates may be slightly lower but there's no tax to pay.

3. Children's savings account trap. Parents who put money into a children's savings account also risk getting caught, Suter added. “A sneaky tax rule means that once a child earns £100 interest on money gifted by parents, it is taxed as if it’s the parent’s money.”

The aim is to stop parents stuffing large sums into a children's account to avoid paying tax.

When interest rates were at historic lows, it wasn’t much of a concern. But if you have £2,000 in a children's account paying 5% you will hit that £100 limit, Suter said. “All interest is then counted as though it’s the parents, not just the interest over £100.”

This won't be a problem if you have left over PSA, but it will be if the interest tips you over the limit.

The £100 rule only applies to money gifted by parents. It doesn’t apply to money given by grandparents and others.

Suter said the £100 limit is per parent. “If you gift the money via a joint account, HMRC will assume the money came 50:50 from each of you, doubling the limit.”

That way, you use both your PSAs, too, she added. Alternatively, use the tax-free £9,000 Junior Isa allowance.

4. Joint account danger. Joint savings account can also trap the unwary. Many couples failed to realise that interest is split equally between the account holders.

So if the account generated £1,000 of interest, each partner would have £500 towards their PSA, Suter said. “If one partner is in a lower tax bracket, consider moving savings into their name. The interest will then be taxable at a lower rate.”

A higher-rate taxpayer who earned £1,000 of taxable interest would pay £400 to HMRC, but a basic-rate taxpayer would only pay £200, she said.

If both partners are in the same bracket but one hasn't exhausted their PSA, consider moving savings into their name.

5. Not realising income is interest. Sometimes, you may be earning interest without realising it. So-called peer-to-peer (P2P) lending is not as popular as it was, but the income may qualify as interest and therefore count towards your PSA, Suter said.

And while the income from most investment funds is taxed as dividends, if the fund is more than 60% invested in bonds and cash, it’s taxed as interest and counts towards the PSA.

“Your investment platform should send you a tax statement showing your annual interest, to help with your calculations, Suter said.

You can get round this by using your Isa allowance, or moving investments into the name of a spouse or civil partner, or putting your money elsewhere. There may be more tax traps out there, so watch your step.