28 November 2014 : 
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Guide to savings accounts

3. Tax and UK savings accounts

UK Income Tax

Any money you are paid in interest on your current and savings accounts is classed as income by the Inland Revenue. This means you will have to pay tax on the interest earned.

The amount of tax you will pay depends on how much taxable income you have.

Every adult in the UK is entitled to a tax-free allowance. This changes each tax year (the tax year runs from April to April) but currently stands at £7,475 You will not have to pay tax on anything you earn up to this amount.

Anything you earn over this amount is taxable income. The tax you then pay is based on a band system as follows (on these amounts above £7,475):

Taxable Bands Allowances 2011-12

Starting rate = 10%        £0 - £2,560
(for savings) 

Basic rate = 20%            £0 - £35,000
 
Higher rate = 40%          £35,001 to £150,000

Additional rate = 50%     Over £150,000

If you earn £14,000 you will not pay tax on the first £7,475. On the next £6,525, you will pay 20% tax.

This is important in relation to the tax you will pay on any interest earned in a savings account because the tax band you fall into will determine the percentage of tax charged on your interest.

If, for example, you earn £7,476 (this is £1 over the tax-free allowance - we have used this exact figure for illustrative purposes), anything you earn in interest on your savings will be charged at the basic rate of 20% because this income will have pushed your total income into the higher banding.

How do they calculate how much tax I have to pay on interest earned in a savings account?

Some savings accounts allow you to earn tax-free savings. Look out for ‘Tax-free’ in the savings accounts descriptions later in the guide as a clear indicator of where you can save without paying tax on your interest.

If your non-savings income is between £0 and £2,560 (between £7,475 and £10,035 taking into account the tax-free allowance) - or if you only get income from your savings and investments - you will pay 10% tax on the income/interest you earn up to a value of £2,560 (on top of the £7,475 tax-free allowance) from your savings. If you have non-savings income which means you end up earning more than the starting rate of £2,560 (£10,035 including the tax-free allowance) per year, all of your savings will be taxed based on the other income-based tax bands, depending on the value of your total income.

You don't have to pay tax on your interest if you earn less than £7,475 per year. However, you will only get your savings tax-free if you fill out form R85 and give this to your bank. This form will be your way of telling the bank that you earn below the tax-free allowance and therefore do not have to pay tax on interest earned from your savings.

To work out how much tax you pay on your interest (if it is not done automatically – most of the time it is) you can use a simple formula. However, first, you need to look at which tax band your interest will be charged at by looking at the table above (if your salary is £21,000, for example, then the tax charged on your interest will be at 20%).

Banks only pay interest at the basic rate of tax of 20% (they will not charge 40% tax on interest earned).

If you fall into the ‘Starting rate’ band, you will be paying too much tax on your savings’ interest. You can claim this back from the Inland Revenue using form R40.

If you fall into the ‘Higher rate’ band, you will be paying too little tax on your savings interest. You will have to declare this when you do your tax return and pay the additional 20%.

To get an idea of how much tax you will pay on your savings interest you need to multiply the gross interest earned (not including your original deposit) by:

0.9 - If you are in the ‘Starting rate’ band (earn between £0 and £2,560 from savings income only)

0.8 - If you are in the ‘Basic rate’ band (earn between £7,476 and £42,475)

0.6 - If you are in the ‘Higher rate’ band (earn between £42,476 and £150,000)

0.5 - If you are in the 'Additional rate' band (earn over £150,000)

In Example 1 above you would calculate the tax as follows:

Interest earned = Figure after 12 months – Original deposit

                                      = £1,052.50 – £1,000
                                      = £52.50

Net interest earned = Gross interest earned x relevant band figure (as above)

                                     = £52.50 x 0.8 (‘Basic rate’ band figure)
                                     = £42.00

Tax paid = gross interest – net interest

                                      = £52.50 - £42.00
                                      = £10.50

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