SAVINGS - income tax

Before we look at how you can use your family to save tax on your savings income, it’s important to understand how savings income is taxed.

Personal savings allowance (PSA)

Every basic rate taxpayer in the UK currently has a PSA of £1,000. This means that the first £1,000 of savings interest earned in a year is tax free and you only have to pay tax on savings interest above this.

If you are a higher rate taxpayer (40%), your PSA is cut to £500, while 45% taxpayers get no PSA at all. Any savings income above the PSA will be taxed at your marginal rate of tax. For example, to exceed the limit a basic rate taxpayer would need a savings pot of £100,000 earning interest at a rate of at least 1% p.a.

Be careful, however, as it’s not just your savings at the bank or building society you have an account with that count towards your £1,000 interest amount. If you own corporate bonds or government gilts that also pay interest, this will be included. Additionally, if you invest in a unit trust or similar funds that pay an “interest dividend”, or earn interest on a life insurance bond such as a with-profits bond, this too will count towards your total allowance.

Example

In 2023/24, Rosie (not a Scottish taxpayer) earns £65,000, and has savings income of £750 (paid gross by her bank). As her earnings take her above the £50,270 basic rate threshold, her PSA will be £500 and she’ll have to pay 40% tax of £100 on the remaining £250 savings income.

Note. Before 6 April 2016 banks and building societies used to deduct 20% tax from the interest they paid to individuals. From that date, such interest is paid gross. This means it is now down to the individual saver to settle any tax payments they need to pay.

 

0% savings starting rate

Low-income earners can also benefit from a 0% “savings starting rate” of income tax for up to £5,000 of savings interest. This reduces for every £1 you earn over the personal income tax allowance of £12,570 (2023/24 tax year). So, if you have earned income of £13,000, your 0% starting rate for savings would be a maximum of £4,570 (£5,000 allowance less £430 over your personal allowance).

Note. You do not need to take dividends into account when deciding whether the 0% savings starting rate is available, which can be very useful for company owner managers.

If your overall taxable income is £18,570 or less, you may not need to pay tax on your savings income. This amount is made up of your annual personal allowance, plus the 0% rate for £5,000 of savings income, plus the £1,000 PSA.

The 0% starting rate is applied to savings income in priority to the PSA. The PSA covers the first £500 or £1,000 not covered by the 0% starting rate - even if no 0% starting rate is available.

Example 1

Pete’s employment income was £13,000 and his savings interest was £3,000. In 2023/24 he would have to pay tax of £86 on his employment income ((£13,000 - £12,570) x 20%) but none on his savings income as it is all covered by the 0% starting rate.

 

Example 2

Tom (not a Scottish taxpayer) has earned income of £16,000, savings income of £2,500 and dividend income of £2,000. He has to pay tax at 20% on £3,430 of his earnings (the amount left once his £12,570 personal allowance is used). He has £1,570 of the 0% starting rate for savings band available as his earned income is less than £17,570. So, the first £1,570 of his savings income is taxable at 0%. As his adjusted net income (which includes dividends) is £20,500, his PSA is £1,000. This means that the remaining £930 of his savings income falls within the PSA and there’s no tax to pay on it. He also doesn’t have to pay any tax on his dividend income as it falls within his dividend allowance of £2,000.

If Tom had earned income of £16,000, savings income of £2,500 and dividend income of £40,000, he would pay tax at 20% on £3,430 of his earnings. He would still have £1,570 of the 0% starting rate for savings available so, the first £1,570 of his savings income would be taxable at 0%. But as his adjusted net income is now £58,500 and over the £50,270 basic rate threshold, his PSA is cut to £500. This means that he has a tax rate of 0% on a further £500 of his savings income and he must pay tax at 20% on the remaining £430 of his savings income (as it is taxed before dividends and falls into the basic rate band) - £86 tax. He does not have to pay tax on £2,000 of his dividend income as it falls within his dividend allowance. He must pay tax at 8.75% on £29,770 (within the basic rate band) and at 33.75% on £8.230 (within the higher rate band).

 

Does ISA income count towards your personal savings allowance?

If you have a cash Individual Savings Account (ISA), the interest you receive is completely tax free and does not count towards your PSA.

For 2023/24, both you and your spouse can each save up to £20,000 in ISAs. Therefore, as a couple, you can shield a maximum of £40,000 in the 2023/24 tax year.

Crucially, any unused allowance doesn’t roll over, so to make use of the current allowance you need to have saved or invested into an ISA by 5 April 2024.

Any savings or investments which stay within the tax-free ISA wrapper will continue to earn interest and reap the tax benefits until you withdraw the money.

 

What about interest from National Savings & Investments (NS&I)?

There are a number of NS&I products which are expressly free of tax, for example, fixed interest and index-linked National Savings Certificates and Premium Bonds. Income from these products also doesn’t count towards your PSA.

NS&I is backed by the Treasury so a non-tax advantage is that you don’t need to worry about the £85,000 Financial Services Compensation Scheme limit.

Note. Interest on other NS&I products such as the investment account, income bonds and direct saver account is taxable and does count towards your PSA.

Both you and your spouse can each hold up to £50,000 in Premium Bonds and any winnings will be completely tax free.

But bear in mind that although there’s no risk to your capital, the downside is that you do not have a guaranteed return on that capital. However, if you hold the maximum £50,000 you are more likely to get closer to the 3.3% p.a. (March 2023) prize fund interest rate as a return. Plus you’re always in with a (very tiny) chance of winning a £1,000,000 tax-free prize.

 

Can you transfer your savings to your spouse to avoid paying tax?

Transfers of cash between spouses can generally be made with no tax problems. Any savings interest will benefit from your spouse’s personal income tax allowance (£12,570 for 2023/24), 0% starting rate and PSA.

Example

Lesley has employment income of £95,000 p.a. and savings income of £4,000. As her earned income is over £17,570, the 0% savings rate is not available and as a higher rate taxpayer, she only gets a PSA of £500. Therefore, she has to pay tax of 40% on £3,500 of her savings income - £1,400 tax.

Lesley’s spouse only receives a small pension of £10,000 p.a. As this is below the personal allowance, he doesn’t pay any tax on it. If Lesley transferred all her savings to him, he wouldn’t pay any tax on the savings income as it would all fall within the 0% savings starting rate band - a saving for the couple of £1,400 in tax.

It’s effective only as long as the transfer is a genuine gift. The gift would not be genuine for these purposes if it was conditional or if the cash could become repayable to you. Any income on a gift that is not genuine would continue to be taxed on you as the donor.

Warning! Watch out if your spouse is not domiciled in the UK and not “deemed” domiciled. The general rule is that gifts in the seven years prior to death are potentially liable to inheritance tax, but gifts between spouses are exempt. If your spouse is domiciled in the UK, there’s no limit on this exemption, but if they are domiciled outside of the UK, there is a limit of £325,000. There is no tax charge if you die more than seven years after making a gift.

 

Do you have to split the income on a 50:50 basis in joint savings accounts?

By default, any interest you earn on a savings account held jointly with your spouse is allocated on a 50:50 basis.

Example

Rosie and her husband, Adam, have £100,000 in a joint savings account which earns 1.5% interest, i.e. £1,500, per year. HMRC automatically assumes that each of them has earned £750. Being a higher rate taxpayer, Rosie only has a personal savings allowance of £500 and has to pay tax of £100 (£250 x 40%) on the savings income. Adam is a basic rate taxpayer, so all his income falls within his £1,000 personal savings allowance.

As the example shows, allocating the income 50:50 is not always tax efficient - you want more of the income allocated to the spouse with the lower marginal tax rates.

Example

If Rose and Adam could elect to split the interest earned on the joint account in the ratio 1:2, then Rosie would be allocated £500 and Adam £1,000. Both these amounts fall within their respective PSAs so they would save £100 in tax compared with allocating the interest 50:50.

 

Can you elect for a different allocation?

Since 2011 spouses have been able to elect for unequal beneficial interests, allowing them to receive interest in a ratio that actually reflects the underlying funds in the account - or how they agree between them that the capital is held.

To make a declaration, use our allocation of savings interest agreement to amend the ratio of the beneficial ownership and hence how interest will be taxed. You need to send this to HMRC along with a Form 17 (https://tinyurl.com/jhnwesz) within 60 days of Form 17 being completed.

 

How can your company pay tax-free interest of up to £6,000 on any cash you lend to it?

If you trade through a company that needs extra cash and you have the funds available sitting in a savings account earning a negligible amount of interest. In this case, there’s nothing to stop you formally lending the money in your savings account to your company. Your company can pay you interest on the money - with up to £6,000 of it tax free.

Example

Wendy takes a salary of £12,570 and dividends of £37,700 from her company, which has her and her spouse as employees. In 2023/24 the income tax on this mix is £3,211 ((£37,700 - £1,000 dividend allowance) x 8.75%). If she were to inject some cash into the company such that she could charge the company £6,000 interest, and only take £31,700 dividends, this tax would fall to £2,686- a saving of £525. This is because there would be no tax to pay on the interest - £5,000 is covered by the 0% starting rate and £1,000 by the basic-rate PSA.

The company would also enjoy a saving of £1,500 (at a 25% corporation tax rate) because the interest would be deductible for corporation tax purposes - provided it’s paid at a commercial rate.

To give an idea of what a commercial rate is, get your clients to obtain quotes from lenders in the name of the company. A small business is viewed as a risky borrower, so rates of 6% and higher shouldn’t come as a surprise. Keep the quotes as evidence if HMRC queries the arrangement.

A rate of 6% or 7% is likely to be much higher than the best ISA or interest-bearing deposit investments, so it could be worthwhile converting these types of asset.

 

Can your spouse get up to £6,000 in interest tax-free too?

There’s nothing to stop your spouse lending money to the company as long as the interest rate is commercial. By getting the company to pay them interest, you can take advantage of their own £5,000 0% savings rate (providing their earned income is below £12,570 in 2023/24) and PSA. As a couple, depending on your other income, you could withdraw up to £12,000 in interest from the company completely tax free.

CHILDREN

Can you transfer savings to your children to avoid paying tax?

Children have the same annual personal income tax allowance as adults (£12,570 for 2023/24). This means your children can receive income up to this amount before being taxed on it. They can also take advantage of the 0% savings starting rate and PSA. But most children won’t use all of these allowances, so it would be useful if you could transfer some of your savings into your child’s bank account to benefit from tax-free interest.

£100 income limit

Unfortunately, there’s a catch. Children under 18 can only receive income of up to £100 (gross) on money given to them by their parents. The savings amount required to generate this level of income is around £3,333 assuming an interest rate of 3% (children’s accounts tend to have higher rates of interest).

Note. If the income exceeds £100, the parent is liable to tax on the whole of the income, not just the excess over £100.

Example

Mr and Mrs Jones opened a savings account for their daughter Bridget when she was born and have been adding money to it each birthday. Last tax year the interest received on the account was £195. As the gifts were made jointly by Mr and Mrs Jones, they don’t need to include them on their tax returns as they fall within the £100 limit. However, if interest rates have risen slightly and the interest is likely to exceed £200, then Mr and Mrs Jones will be liable to tax on all of it, not just the amount over £200.

The £100 exemption applies for each parent and each child. If you have four children, you and your spouse between you could divert capital that would produce up to £800 (£100 each x four children) of tax-free interest in your children’s names.

 

Is there a way to get around the £100 income limit?

Only income arising from parents’ gifts to their children falls into the £100 income limit trap. Gifts from grandparents, aunts and uncles, godparents and other relatives and friends are not subject to the £100 limit.

Note. Parents giving cash to a grandparent which the grandparent then gifts to the child will fall foul of HMRC’s general anti-abuse rule.

Open a separate account for your children for gifts from others, e.g. grandparents. The interest on this will be tax free provided your child’s total income is within their personal income tax allowance.

If you want to draw money from one of your child’s accounts, take it from the one into which parental gifts are made to help reduce the interest.

 

Are Junior ISAs subject to the £100 limit?

Similar to adult ISAs, children can set up a Junior ISA to keep savings in a tax-free wrapper. Junior ISAs allow anyone, including parents, to invest up to a maximum annual amount (£9,000 for 2023/24) for children under 18 in any combination of qualifying cash or stocks and shares investments and for the interest, dividends or gains from them to be tax-free. Funds parents invest into their children’s Junior ISAs are not subject to the £100 limit.

There are drawbacks to Junior ISAs; the main one being that the money is locked in until the child turns 18.

The Junior ISA limit is per child and not per parent so if you have two children, you can invest up to £9,000 into Junior ISAs for each of them.

In the past, private school fees have often been funded by grandparents through accumulation and maintenance trusts, but due to changes in how trusts are taxed, these are no longer so tax efficient. Therefore, the funding of private school fees may fall more heavily on parents than on grandparents now. However, grandparents could regularly contribute into a Junior ISA to, for example, help your child with the cost of university fees or a deposit for their first home.

 

If your child has a Child Trust Fund - can you open a Junior ISA for them?

No. Child Trust Funds (CTFs) were set up for any child born between 1 September 2002 and 2 January 2011, often with the government contributing £50 to £1,000. Those with Child Trust Funds cannot open a Junior ISA - they’re only for children born before or after these dates.

CTFs and Junior ISAs are now almost identical - a place to save or invest up to £9,000 per year tax free. The bad news is that as CTFs are a closed market, fewer providers offer them, so there’s less competition.

If your child has a CTF but you’ve found a Junior ISA with a more competitive interest rate, then consider whether you should switch the CTF to a Junior ISA.

 

Can you invest in Premium Bonds for your child?

Yes, you can. Currently children under 16 can hold up to £50,000 of Bonds and anyone can buy the Bonds for them.

Although the Bonds will be in the child’s name, the purchaser needs to nominate the child’s parent (or guardian) on the application to manage and cash in the Bonds.

 

Will you be taxed on your child’s Premium Bond winnings?

No. The prize itself isn’t subject to tax. But will you fall foul of the £100 rule once you remove the winnings from NS&I and place them into a child’s savings account?

The short answer is no. It’s important to remember that Premium Bond winnings aren’t gifted by parents. The winnings, whether £25 or the top £1m, are a prize from NS&I. This means they aren’t subject to the usual £100 income rule on children’s savings. HMRC says that any prize is capital (which belongs to the child) not income and if that capital gives rise to taxable income, the income is the child’s. The parent did not provide the prize money, so the £100 rule does not apply.

 

Are there any other tax-free investment options for your children?

If you’ve used up your child’s Junior ISA allowance, another tax-free option which doesn’t contravene the £100 limit for payments made by parents is a friendly society bond.

Long before ISAs appeared on the scene certain types of insurance company, namely “friendly societies”, were offering tax-free investments. HMRC allows special treatment for friendly societies that trade mutually, i.e. the profit they make is paid out to, or used only for the benefit of, its members (investors).

The tax-free investments offered by friendly societies go under a variety of names, for example family saving plans, family bonds and children’s bonds. Whatever their name, they can easily be recognised by the terms and conditions that apply:

•       the maximum investment is £25 per month for each investor

•       if the investment is made once per year rather than monthly the maximum amount is reduced to £270

•       the investment must run for at least ten years to maintain its tax-free status.

Although you can stop paying into the savings plan at any time and get your money back, along with any growth in value, the tax-free status is lost if you cash the bond in within the first ten years.

Invest for all family members - friendly society tax-free savings are open to investors of any age. For example, a family of four can invest up to £1,200 per year into a friendly society savings plan.

As an added bonus, this type of investment is usually linked to a life insurance policy that will pay out a guaranteed sum in the event of the death of the investor. Typically, this will be the greater of around ten times the amount of the annual investment or its value.

Don’t be lured into buying a friendly society bond etc. before checking the investment track record. Tax-free status isn’t a guarantee of a good investment and many of these friendly society bonds give poor returns compared with other investments.

an you contribute to a pension for your children?

Starting a pension for your child might seem like an unusual savings option. However, you can put up to £2,880 per tax year (£240 per month) into a pension for each child regardless of whether they have any earnings. The pension scheme can then claim a basic rate tax relief top-up of £720 from the government which turns your £2,880 contribution into a £3,600 pension pot.

If £240 net per month (so £300 gross) is paid into a child’s pension from birth to age 18 and assuming investment growth of 4% per year (net of charges), about £95,000 in today’s money would be accumulated by the time the child is 18. If this were then left to grow until the child reached pensionable age, the pension fund would be about £500,000. The actual return would of course depend on the performance of the fund.

Making contributions in this way to a pension scheme could well be a useful method for wealthy grandparents to extract money from their estates for inheritance tax purposes. Provided the payments are regular (for example, are paid by monthly direct debit), are paid out of income, and do not diminish the normal standard of living of the grandparents, they should fall within the “gifts out of normal expenditure” exemption.

The downside of this planning is the fact that the child cannot access any of the pension funds until at least the age of 57 (increasing from 55 from April 2028). However, planning of this kind may be particularly helpful where there is concern over an impetuous child and the grandparent wishes to fund an investment for later life.

 

Are there any CGT implications of transferring cash savings to another family member?

From a CGT perspective, as long as you aren’t encashing investments where there is a capital gain, then there won’t be any CGT to pay on any cash gifts to other family members. This is why giving cash away is usually seen as the safest way to make a gift to another family member.

INHERITANCE TAX CONSIDERATIONS

What are the IHT implications of giving cash away?

The general rule is that cash gifts made in the seven years prior to death are potentially liable to IHT. However, there are a number of exemptions available which could make the cash gift completely IHT free even if you die within seven years of making it.

 

How can making regular gifts help reduce IHT?

One of the simplest IHT planning steps is to start making regular gifts out of income. This won’t reduce the value of your existing estate, but it can keep it in check. By giving income away you can stop capital from building up.

 

How much cash can you give away?

One difficulty with the gifts out of income exemption is working out how much you can give away without breaking the rules. There are two main conditions:

Part of your “normal” expenditure

“Normal’ for this purpose means regular or habitual, such as gifts at Christmas and on birthdays, or those of a recurring nature. Generally speaking, a one-off gift out of your income won’t qualify.

As evidence to rebuff a potential HMRC challenge, make a written declaration of intention to make normal gifts out of income and set up standing orders for the regular cash gifts.

Out of surplus income

A gift only counts as IHT exempt where it comes from income left over after you’ve paid your normal living costs, e.g. food bills, domestic costs etc. However, it’s no use reducing these costs so you can make IHT-exempt gifts of income, HMRC won’t accept this. You can’t, for example, give away your entire annual remuneration to pay for university fees and then dig into your savings to provide for yourself.

Keep a record of such gifts in case HMRC asks for evidence later on. Use our surplus income record on an annual basis to record any gifts made as part of normal expenditure out of income.

 

What if your income drops in one year?

If your available income is less in one year because of unexpected expenses, e.g. short-term nursing care, these can usually be ignored.

Example

Tony started to make regular gifts to his grandchildren. But his net income dropped in 2022/23 when he had to spend some time in a nursing home to recover from heart surgery so he’s having to eat into capital to fund the gifts. The gifts out of income exemption can still apply if his income recovers sufficiently that the value of the gifts is covered. The law says “taking one year with another” when considering whether you have enough income. So if Tony’s income wasn’t sufficient in 2022/23, as long as his 2023/24 income will be enough to cover the shortfall, plus any gifts out of income for 2023/24, the exemption can still apply for both years.

 

Are there any other ways to make cash gifts IHT free?

Some cash gifts count for IHT purposes but are specifically exempt from any tax charge. To start with the first £3,000 of any gifts in a tax year will be IHT free = this is the annual exemption.

If you didn’t use the £3,000 annual exemption in 2022/23, you can carry it forward to the next tax year, i.e. 2023/24.

Example

Simon didn’t make any cash gifts to his children in 2022/23. This means that on 6 April 2023 he can gift up to £6,000 out of capital completely IHT free. As he’s used his full £3,000 allowance in 2023/24, his allowance for 2024/25 will drop down to £3,000 again.

Note. The current year’s exemption must be used up first before any unused part of the previous year’s allowance. Any part of the previous year’s allowance not used in the current year is lost.

Example

Taking the example above, if Simon only made a capital gift of £5,000 to his children in 2023/24, this will be allocated as £3,000 of the current year’s annual exemption and £2,000 of the previous year’s annual exemption. He can’t carry over the remaining £1,000 exemption relating to the prior year so his allowance for will still only be £3,000.

The £3,000 gifts should be made regularly so as to ensure that the exemption (with the right to be carried forward for one year only) does not lapse.

You and your spouse together can give away £60,000 under this exemption over ten years - a potential IHT saving of £24,000.

The exempt gift need not actually be cash. It could be assets such as shares or jewellery.

Make sure the gift is made and shown to be made out of capital rather than your income so as not to be confused with your regular gifts out of income. For example, make any regular gifts out of income from your current account and any capital gifts from a savings account.

Ensure that both you and your spouse have sufficient funds in place so that each of you can make gifts. Simply gifting cash to your spouse so that they can then make a cash gift to your child could be regarded as an “associated operation”.

A precautionary step to prevent this would be to ensure that you record the initial gift to your spouse in a signed memo, stressing that the gift is made to your spouse as beneficial owner absolutely and unconditionally (see our memorandum and deed of gift document).

 

Can you make any other IHT-free capital gifts on top of the £3,000 IHT annual exemption?

Yes, you can but there’s a trap if the gift is to the same person.

Small gifts

In any tax year, you can make any number of IHT-exempt gifts of up to £250 per recipient. There’s no restriction on the number of gifts made. However, if a gift of £3,000 is made to a recipient, the whole lot will be potentially chargeable to IHT not just the amount over £250.

A £250 gift won’t be IHT-exempt if it is given to someone who received a gift from your annual exemption. So you can’t use the small gifts exemption and your annual IHT allowance for gifts to the same person in the same tax year.

To get around the problem, in the current tax year you give £3,000 to your son and £250 to your daughter. Your spouse does the opposite and gives £3,000 to your daughter and £250 to your son. That way, you can both make use of the annual and small gifts exemptions.

Gifts in consideration of marriage

Parents can give an IHT-exempt £5,000 to each of their children as a gift in contemplation of a wedding or civil partnership. Grandparents and great-grandparents can give £2,500 and anyone else £1,000. Parents can also give £2,500 to the person their child is marrying. These gifts can be made on top of your annual IHT allowance.

Where the wedding gift exceeds the IHT-exempt limit, only the excess is potentially chargeable to IHT.

Discounted gift trust

The problem with giving cash away during your lifetime is that you will lose out on the interest income. If this is a concern for you, a discounted gift trust might be the answer. A discounted gift trust allows you to make a gift of cash while retaining a right to fixed regular payments for the remainder of your lifetime.

It’s called a discounted gift trust because the value of your gift for IHT purposes is discounted by the estimated value of these future payments to you. The discount is based on your life expectancy and the level of the regular payments.

As the cash gift is separately identifiable from your right to future payments, there’s no gift with reservation for IHT purposes.

Example

You put £1m cash into a discounted gift trust and set your income level at 5% p.a. (i.e. £50,000 p.a.). The gift is actuarially discounted to £230,500, so £769,500 is outside your estate immediately. This results in a potential IHT saving of £307,800.

 

How is the trust created?

The trust is typically established by you making a cash gift to the trustees. It isn’t normally possible to use an existing bond or other investment to create the trust - these will generally need to be cashed-in and the proceeds used to establish the discounted gift trust.

The trustees then invest the trust funds by taking out an investment bond (onshore or offshore). Regular withdrawals are then set up to provide your regular payments out of capital. The use of non-income-producing assets such as bonds means there’s no trust tax reporting needed unless there’s a chargeable gain.

 

What about IHT on the gift to the trust?

If the gift is to a flexible or discretionary trust, then it will be a chargeable lifetime transfer which means that the gift will be subject to IHT at the lifetime rate of 20% if it is valued at more than the £325,000 IHT threshold or you have already used up the IHT threshold on other chargeable lifetime transfers. However, the value of the transfer for IHT is the discounted amount so in our example above, the £1m cash gift was valued at £230,500 which is below the £325,000 IHT threshold so there’s no tax to pay.

 

Gift and loan arrangement

Another way to reduce the value of your estate for IHT purposes is the gift and loan arrangement which works as follows:

•       you make a non-interest-bearing cash loan into a trust

•       the trust invests the cash

•       the loan remains an asset within your estate but any growth in the value of the investment in the trust is outside your estate

•       you can recall the loan (but not the growth) how and when you like

•       you can cancel the loan (or part of the loan) at any point but this will be a gift subject to the usual seven-year rule.

Example

Bob loans £100,000 to a trust. The trustees invest the cash and over the next 20 years the value of the investment increases to £300,000. When Bob dies 20 years after making the gift to the trust, the £100,000 loan will be included in his estate but there will be no IHT to pay on the £200,000 growth.