I’m being dragged into owing tax on savings – how do I pay it?

Tax thresholds were frozen in Wednesday’s Budget – and extra taxes were added for savers

In our Budgeting Clinic series, Tom Francis, head of personal finance at Octopus Money, answers your questions about all things personal finance. Tom is a fully qualified and chartered financial planner. Worried about how your savings are shaping up for the future, or need a plan for how to get out of debt? Drop him an email on money@theipaper.com.

Question: I’ve only ever been a basic-rate taxpayer but next year my wage is set to cross the £50,270 threshold. With thresholds being frozen, this means that I’ll be a higher-rate taxpayer for the first time. I know this means I’ll have to pay tax on my savings, as I tend to earn £700 a year. I don’t mind too much about paying the tax as I assume it won’t be too much, but what do I need to do about paying it? Do I have to keep money aside and declare it to HMRC, is it taken automatically? It’s more the administrative side of things that is worrying me.

Answer: First up, kudos to you for having your finger on your personal finance pulse so closely and a big congratulations on your pay rise. Before jumping into worries or concerns, it’s worth taking a moment to recognise how far you’ve come. Crossing into the higher-rate band can sound daunting, but it also reflects real progress in your career.

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And, you’re absolutely right to get ahead of the admin. Income, savings and taxes are three crucial pillars which our financial futures are built on top of, so being clear about how they impact you is crucial. Tax is a horrible word and can be confusing for many people, but moving into a higher band doesn’t mean you end up worse off. You’ll still take home more pay overall – the higher tax rate only applies to the slice of income above £50,270.

Why this is happening

Now to the frustrating part. In Wednesday’s Budget, the Government confirmed that the income tax thresholds are going to remain frozen through to 2030/31.

For many, this doesn’t sound like a particularly painful thing, as rates at least are not increasing. But, you have hit the nail on the head in the fact that you are soon to find yourself paying more tax than previously, and you’re certainly not alone in this.

Historically, tax bands have roughly risen with inflation, but now they will be fixed from 2021, up to 2030 at least. If we look at just the years between 2021 and 2025, inflation has meant that prices have risen by 25 per cent over that time.

The fact that tax bands have remained frozen means so many more people, like you, are paying higher-rate tax at 40 per cent, instead of the basic rate at 20 per cent.

What it means for your savings

If you are earning around £700 in interest from your savings, you are correct, as a higher-rate taxpayer your “personal savings allowance”, that is the amount of interest you can receive tax-free, falls from £1,000 per year, to £500 per year.

This means that £200 of your interest will now be taxed at your new marginal savings rate of 42 per cent. (This rate was increased by 2 per cent on Wednesday). This would equate to roughly £84 in additional tax.

The good news: you usually don’t have to do anything.

The most common mechanism for this tax to be collected would be via a change in your tax code. Every year, banks report to HMRC how much interest individuals earn, and then HMRC will work out who might need to pay more tax.

You could expect HMRC to send you a letter, after the end of the tax year, letting you know that some extra tax is payable, and that they will adjust your tax code to collect this extra amount over the next year. 

If you prefer to pay it upfront instead, you can contact HMRC – but most people just let the tax code change automatically.

A few opportunities to consider

I wouldn’t be doing my job if I didn’t help you understand all of the options available to you, which might help you to reduce the amount of tax that you pay, or get your savings working slightly harder for you.

First up, it’s important to check the optimal amount of cash for your circumstances and goals.

If you are earning around £700 in interest, assuming a 4 per cent interest rate, this would suggest you hold around £17,000 in savings or so. This might indeed be optimal for you, but we recommend checking two things when calculating suitable cash balances.

Firstly, what’s your target rainy day fund? We usually recommend around three months of outgoings for this.

Secondly, what things will you be spending big on in the next three to five years (dream holidays, home renovations, gifts for family). If you find your cash target is less than the balance you hold, then considering investments and/or pensions could be sensible.

Really importantly, if you have any ISA allowance available, this would be a very sensible option to protect the interest you are receiving from tax. A cash ISA would immediately protect your future interest from any tax being applied.

You may read that the Government is reducing the allowance to £12k from 2027, but that’s usually plenty for most savers.

If you’re comfortable tying money up for five years or more, then you could consider a stocks and shares ISA.

This gives you the opportunity to invest some of your savings, with the goal of earning a return above what you might get with cash-based savings. Of course, this isn’t guaranteed, however, time really helps smooth out the ups and downs of investing.

What this means for you now

There’s no extra admin you need to be worried about as part of your pay rise, HMRC can sort it all in the background. The fact this is top of mind for you suggests you’re much more financially resilient than you might think. Take this as a moment to reset and refresh your financial plan. And if you don’t have a plan yet – there’s no better time to start.

As a final point, please note this is not intended as financial advice, but for guidance purposes only. Tax rules relating to ISAs, GIAs and SIPPs are subject to change and depend on individual circumstances.