Tax on savings and investments – why it matters

In general, you pay tax on savings. Basic-rate taxpayers pay the taxman 20% of the interest they earn, while higher-rate taxpayers pay 40%. However, recent changes mean many taxpayers may no longer have to pay tax on their savings interest.

Tax on savings accounts

Previously, if you were a taxpayer you had tax automatically deducted on the interest you earned from your savings. However, in April 2016 a new personal savings allowance was introduced. This means:

  • Basic rate tax payers can earn up to £1,000 interest on their savings without having to pay tax.
  • Higher rate tax payers can earn up to £500 worth of interest tax-free.
  • Anyone who earns more than £150,000 a year does not benefit from the personal savings allowance.
  • Any interest exceeding your allowance is liable to income tax.

There is also zero-tax band on the first £5,000 of savings interest. This means that someone with a total taxable income of less than £17,000 might not pay tax on any savings income.

For more information on Tax on savings interest visit GOV.UK.

Claiming back tax

If you think you’ve overpaid tax on your savings, you can claim it back by filling in form R40 on GOV.UKopens in new window.

Tax-free savings

Some savings products pay interest that is tax-free. This means basic-rate taxpayers save £2 tax for every £10 of interest, higher-rate taxpayers save £4 tax, and so on.

Tax-free savings products include ISAs and some NS&I products, such as savings certificates and Children’s Bonds.

Share-based investments

If you own shares, you may get income in the form of dividends. Dividends are a portion of the profits made by the company that issued the shares you’ve invested in.

If you have an investment fund that is invested in shares, then you may get distributions that are taxed in the same way as dividends.

In April 2016, a new tax-free Dividend Allowance of £5,000 a year was introduced for all taxpayers. Dividends above this level are taxed at:

  • 7.5% (for basic rate taxpayers)
  • 32.5% (for higher rate taxpayers)
  • 38.1% (for additional rate taxpayers)

Any dividends received within a pension or ISA are unaffected and remain tax-free.

Basic rate payers who receive dividends of more than £5,000 need to complete a self-assessment return.

Examples:

  1. If you receive dividend income of up to £5,000 outside an ISA. You will pay no tax on your dividends, even if you are a higher or additional rate taxpayer.
  2. If your total income is less than £11,000 (the current personal allowance), any income is covered by your personal allowance. You will have no tax to pay as your dividend allowance of £5,000 is untouched.
  3. If your dividend income is received within an ISA, it will remain tax-free and the dividend allowance will not impact any income you receive.

Tax-efficient investments

Generally speaking, stocks and shares ISAs are useful if you pay income tax at a higher or additional rate. However, it’s good idea to weigh up the pros and cons if extra charges are involved.

In April 2016, a new £5,000 tax-free Dividend Allowance was introduced. This means that any dividend income above £5,000, received outside of an ISA, will be taxed at:

  • 7.5% (for basic rate taxpayers)
  • 32.5% (for higher rate taxpayers)
  • 38.1% (for additional rate taxpayers)

Any profit from shares rising in value is completely free of liability for Capital Gains Tax if you hold them through an ISA. However, because this annual tax exemption is relatively generous for the majority of investors, you might not have had to pay this tax anyway.

Where the investments in your stocks and shares ISA do not pay dividends, but instead pay interest (for example, government and corporate bonds), the interest paid remains tax-free.

Life-insurance investments

One way to invest in investment funds is through a life insurance policy.

The insurance company owns the funds and has to pay tax on income and gains they make. When the proceeds are paid out to you, they always count as income and you are treated as if tax at the basic rate of 20% has already been deducted.

This tax can’t be reclaimed, but if your top rate of tax is the basic rate or less, there is no more tax for you to pay. Higher-rate and additional-rate taxpayers have to pay extra tax of 20% and 25%, respectively, unless the insurance policy is ‘qualifying’, in which case there is no extra tax.

Policies where you pay regular premiums for 10 years or more are likely to be qualifying; policies where you pay a single lump sum premium are not.

Other options

It may make sense to consider other types of investment fund, such as unit trusts and open-ended investment companies (OEICS), rather than life-insurance investments.

With these funds, part of the proceeds you receive count as income (and are typically taxed as described above in the section on share-based investments), while part may come from gains due to rising share prices.

In particular, because you have a capital gains tax-free allowance limit (currently £11,100 a year), you could find you might pay less tax if you hold these types of investment fund rather than some life-insurance investments.

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