Under previous rules, 20% tax was deducted automatically from your savings interest by your savings account provider (unless you filled in a form to state that you were not a taxpayer and should therefore receive your interest gross).
If you were a higher (40%) or additional rate (45%) taxpayer you needed to account for any extra tax you owed via your self-assessment tax return, and pay the taxman direct.
But all of this changed at the start of the new tax year on April 6, 2016, when the personal savings allowance (PSA) came into effect (it was announced in the 2015 summer Budget).
Here’s how the new allowance works, and how it could affect you…
How does the personal savings allowance work?
All basic rate taxpayers can now earn £1,000 of savings interest a year without having to pay any tax on it (you’re a basic rate taxpayer in the 2017-18 tax year if your income is less than £45,000).
If you’re a higher rate taxpayer, paying tax at the 40% rate on an income between £45,001 and £150,000, you have a lower personal savings allowance of £500 a year.
If you’re an additional taxpayer earning £150,001 or more, you don’t get an allowance at all.
The government estimates that the introduction of the allowance means that 95% of savers won’t have to pay any tax on their savings.
Does the allowance apply only to savings accounts?
No, you also benefit from the allowance if you earn interest from your current account, credit union account, or peer-to-peer lending.
The only interest which isn’t covered by the personal savings allowance is interest which is already tax-free, such as interest from individual savings accounts (ISAs) or Premium Bond winnings.
So, for example, if you win £100 from Premium Bonds and receive £100 in ISA interest, you’ll still have your £1,000 personal savings account to cover any other interest you might earn.
How much can I save before I go over the allowance?
That depends on which account you save into and how much interest it pays.
For example, if you save into one of the best easy access accounts paying around 1.5%, and you are a basic rate tax payer, you’d need to have more than £66,000 in your account before you’d generate enough interest to use up your allowance.
If you are a higher rate taxpayer, then you’d need to save half this, at £33,000, before your allowance is used.
How do I claim the allowance?
The good news is you don’t have to do anything to claim the allowance.
As of April 6, 2016, all interest is paid with no tax taken off, so it all happens automatically. If the interest you earn exceeds the personal allowance, then any tax you owe will be paid to HM Revenue and Customs (HMRC) through your tax code.
If you fill in a self-assessment tax return, then you will repay any tax owed this way instead.
What if I didn't previously pay tax on my savings interest?
If your total taxable income is less than £16,500 (the income tax personal allowance of £11,500 plus the £5,000 starting rate limit for savings income), you shouldn’t pay tax on any of your income. This means nothing has changed for you now the personal savings allowance has been introduced.
However, there’s no longer any need for you to notify your bank or building society that you don’t pay tax on your interest.
Is there any point still saving into cash ISAs?
Although you need a large amount of savings to use up your personal savings allowance, bear in mind that once interest rates start to rise, you’ll need to save much less to reach the £1,000 or £500 threshold.
Remember too that any interest you earn from cash ISAs doesn’t count towards your personal allowance, so it’s a good idea to make the most of both.
There are also no guarantees how long the personal savings allowance will be around for, with some financial experts claiming that this is more likely to be changed or reversed in future than the tax benefits of ISAs.
Please note: any rates or deals mentioned in this article were available at the time of writing. Click on a highlighted product and apply direct.