How does the Personal Savings Allowance work?
"I've been saving in an ISA for a few years but now the Personal Savings Allowance has come into effect, is there much point?"
The Personal Savings Allowance (PSA) allows basic rate taxpayers to earn up to £1,000 in interest alone from their savings before they have to pay tax on them.
It's tempting to think that with the low interest rates around at the moment we'd need to have thousands and thousands saved before approaching our PSA - but how accurate is that?
In this guide we look into how where we're saving can affect how close we get to the PSA limits, and how to save more if needs be.
What is the PSA?
The introduction of the PSA in April 2016 marks something of a revolution in the normally staid world of taxation.
It gives each of us the chance to earn £1,000 in interest tax-free if we're basic rate taxpayers, or £500 if we normally pay at the higher rate; additional rate earners don't get a PSA.
To this end, all savings interest will now be paid gross, rather than being taxed as income before being paid to us.
The good news is that we now receive interest at the rates quoted by the providers. But it also means it's now our responsibility to report and pay tax on any interest earned above our PSA at the end of the year.
Range of options
The personal tax-free allowance is renewed each tax year. It applies to interest earned with a range of accounts - from regular current and saving accounts to bonds and P2P lending.
ISAs are excluded as they're exempt from tax anyway.
The other difference is that while the limit with an ISA is on how much we can deposit each year, the limit with the PSA is on the returns.
We're not allowed to invest more than £15,240 net in an ISA over the course of the year - but the only limit on how much interest we can earn is the rate offered.
With a taxable savings account, however, once we've earned up to our PSA in interest, we must pay tax on the rest - 20% on interest earned above £1,000 for basic rate taxpayers, and 40% on anything above £500 in interest at the higher rate.
As, at the time we're writing this article, the best ISA rates are just over 2% AER and many are much lower, it makes sense to consider other savings options that offer higher returns - including those current accounts that offer up to 5% AER.
Staying within the allowance
Even so, for many of us it may seem like there's nothing to worry about - because the chance of earning £1,000 in interest over the course of a year seems rather low.
The table below, for example, shows the interest we'd earn on a variety of balances, at a variety of rates.
Note that, for simplicity's sake, we've looked at average balances.
That is, we're assuming that a saver puts their money into the account on day one of the financial year and leaves it there for the rest of the year - or that any withdrawals they make are balanced by deposits that maintain that average.
|Average balance||Interest paid at|
|1% AER||2% AER||3% AER||4% AER||5% AER|
The amounts marked in bold are those that surpass one or other of the limits set for the PSA; it's clear to see that even with an account that pays an unusually high rate of interest for the present time, we need to have considerable average savings.
Importantly, however, the PSA applies to all of our taxable money, not just the funds we've earmarked as savings - including any interest earned by our everyday bank account.
So how much can we actually save before hitting our PSA?
Again, keeping it very simple and assuming an average balance over the course of the year, the table below shows the maximum that both a basic rate and higher rate taxpayer can save if all of their savings are earning interest at the same rate:
|Interest paid at|
|1% AER||2% AER||3% AER||4% AER||5% AER|
|Basic rate saver||£100,000||£50,000||£33,333||£25,000||£20,000|
|Higher rate saver||£50,000||£25,000||£16,666||£12,500||£10,000|
Bear in mind again that these figures cover all the money we have in all our taxable accounts - including those we use for day-to-day spending.
The case for ISAs
So while ISAs do offer poorer returns, they're still useful - particularly for those who've been saving for a while, and those who pay tax at the higher rate, or think they may find themselves doing so in the near future.
For one thing, ISAs become more valuable over time - and no matter how valuable they become, they're never subject to tax.
For example, a saver who had deposited the full amount in cash ISAs every year since they were launched would have deposited more than £86,000 by now - and their actual balance would be bolstered by years of interest paid tax-free.
Martin Bamford, an independent financial adviser from Informed Choice, says:
"The real value from ISAs comes over time, when you maximise your allowance each year and accumulate significant sums in these tax-free wrappers."
Because ISAs are so well established, it's unlikely future Governments will alter their tax-free status. The newness of the PSA however, means that it could disappear next year, or be changed up or down on the whim of the Chancellor.
Furthermore, though interest rates are low now, at some point they will start to rise again, which will make it easier to reach our own PSA and become liable for tax - but if the interest rates for ISAs increase, we simply get more for our money.
One fairly new, and therefore often overlooked, reason to consider ISAs is that since April 2015, spouses and civil partners have been able to pass on their ISA savings to their partners tax-free.
Where to save
To answer the original question: For those with money to save now, making use of the PSA makes sense - particularly with non-ISA interest rates so favourable.
But those who already have money in an ISA won't lose out by using keeping the money locked up - especially over the long-term.
Remember too, that money in ISAs can be moved to newer, better deals without losing the tax-free benefits - and as the interest rates on many savings accounts drops away over time, it can be wise to do so.
We've a guide on how to go about transferring an ISA here.
In an ideal world, savers will be able to invest in a high-interest easy access account up to a point close to their personal allowance, then funnel the extra into an ISA.
For most normal people however, there's little worry about breaching the PSA. In this case, it's simply a matter of finding the account offering the best rate.