Why Now Might NOT Be the Time to Set Your Savings at 5%

Savers with money stashed away in fixed-rate accounts will soon be faced with a decision about what to do with their savings.

According to Paragon Bank, seven out of ten fixed-rate savings accounts will mature in the next 12 months.

And most of them are one-year fixed-rate accounts, Paragon Bank data shows.

Fixed rate accounts have taken a hit since the Bank of England cut the base rate to 5 per cent earlier this month.

On June 1, there were 25 one-year fixed-rate bonds offered directly by providers rather than through savings platforms with an interest rate above 5 percent; now only a few remain.

But savers can still find accounts that pay this benchmark (or higher) if they shop around.

Rather than keeping savings in another fixed-rate account that pays out when due, more than two million savers with more than £20,000 in their coffers could get higher returns by moving some of their money into an ISA, even if it pays a lower rate.

This is because many savers who are attracted to high-interest savings accounts are falling into a tax trap because the Personal Savings Allowance (PSA) is frozen.

The amount tax savers pay in interest on their savings will rise to £10.37bn in 2024/25, up from £6.6bn in 2023/24, official HMRC estimates show.

Of the £10.4bn expected to be collected in savings interest tax, £1.14bn will come from basic rate taxpayers, £2.4bn will come from higher rate taxpayers and £6.8bn will come from additional rate taxpayers.

CACI data shows that in May this year there were 2.3 million fixed-rate savings accounts earning 2.5 per cent interest and holding £20,000 or more, representing total savings of £151.9 billion.

A savings account with £20,000 in it earning 2.5 per cent interest would earn £500 in interest.

For higher rate taxpayers, because their Personal Savings Allowance (PSA) is frozen at £500, any interest earned on top of this will be subject to 40 per cent income tax.

While fixed-rate accounts can offer higher interest rates than cash ISAs, the tax bill savers will receive on savings interest means tax-free ISAs provide better returns for taxpayers with higher rates and large balances.

For example, a one-year fixed rate account paying 5.15 per cent with a balance of £20,000 would generate a return of £818 for a higher rate pre-tax taxpayer.

If £20,000 is held in a one-year fixed rate account earning 5.15 per cent, it will earn £1,030 in interest. As a higher rate taxpayer, the saver will pay £212 of that in tax, leaving them with a net return of £818, according to Paragon Bank.

If that £20,000 was held in an ISA, it would earn the same return at a rate of 4.09 per cent.

To achieve the same net return from a cash ISA, the saver would need an equivalent rate of 4.09 per cent. Therefore, any ISA offering a rate higher than 4.09 per cent would offer a better return.

The tax on savings interest has a chilling effect on the best savings accounts. It turns Union Bank of India’s brilliant best buy rate of 5.25% into 4.2% if you are a basic rate taxpayer and 3.15% if you are a higher rate taxpayer.

Savers can deposit a maximum of £20,000 per tax year into an ISA and all interest generated is completely tax-free.

Millions more savers have been using Isas to shield their savings from tax as interest rates have risen.

Savers funnelled a record £11.7bn into cash Isa deposits at the start of this financial year, official Bank of England data shows.

This resulted in cash ISAs receiving the largest inflows for the start of the tax year since the tax-free accounts were launched in 1999.

The best way to protect your savings from a tax attack is to keep them in an ISA rather than a standard savings account.

Better still is a flexible ISA, which allows you to withdraw your money and, crucially, pay it back without affecting your annual allowance, as long as you pay it back in the same tax year.

Flexibility is a useful feature to have in an ISA when it comes to keeping as much of your savings tax-free as possible.

Large savers who can max out their ISA limit by £20,000 will see the most benefit from a Flexible ISA.