The Government introduced a Personal Savings Allowance (PSA) in 2016 to encourage more people to put money away, but how you choose to receive your interest could have an impact on whether you breach that allowance, particularly if you save into a fixed-rate term product.

Savers placed £22.5 billion into new fixed-term non-ISA accounts in the final three months of 2022 as they responded to rising interest rates. This was a significant increase on the £8.8 billion recorded in the quarter prior to this and the £3.9 billion placed during the same period a year before.

What is the Personal Savings Allowance?

Through the PSA, basic-rate taxpayers can earn £1,000 interest on savings before incurring any tax, falling to £500 for higher-rate taxpayers. Additional rate taxpayers do not benefit from any PSA.

The PSA only applies to money held outside of an ISA savings wrapper. It’s important to remember your PSA covers any interest you earn from money held within bank accounts, savings accounts, corporate bonds and even investments such as government bonds and gilts. Therefore, savers need to think about their total returns from all of their cash held within these vehicles.

How can savers choose to receive interest payments on fixed-rate products?

As savers have increasingly focused on fixed-rate products in recent months, the question of how they receive interest payments has come to the fore.

Savers can typically choose to receive interest payments on a monthly or annual basis, although some providers will only allow customers to receive interest on product maturity.

They can also usually choose to accumulate the interest back into the fixed-rate account – so they don’t access the cash - or ‘pay away’ the interest to a nominated account, where they would have access to the money.

A third option some banks offer, including Paragon, is to pay the interest into a separate savings account with that provider. 

How can the method by which you receive interest payments impact your PSA?

Under the PSA, the tax liability falls during the tax year the interest is accessible. It does not roll-over with each tax year.

Therefore, savers with a fixed-rate product with a maturity date longer than one year need to factor in how the method of interest payment will impact their PSA threshold.

If you choose to take interest on maturity or roll it into the fixed account annually or monthly, you won’t have access to the interest earned until the end of the fixed period.

For example, a higher-rate taxpayer with a £10,000 balance in a five-year fixed-rate non-ISA account paying 4% would earn £2,209.97 in interest on maturity if they accumulated the interest within the account.

Based on the interest earned being £1709.97 above the £500 PSA, the individual would be liable to pay 40% of that amount in tax, equating to £683.09.

If the same individual opted to pay away their interest into a nominated account, they would receive £407.42 interest on their savings each tax year – below their PSA level and owing nothing to the taxman.

How does paying away impact compound interest?

What savers choosing to pay away should be conscious of, however, is the loss of compound interest. If the interest payment is accumulated within the fixed-rate account each year, the saver earns interest on the interest payment, as well as the initial balance.

In the case above, that makes a £172.97 difference in overall interest earned on the £10,000 balance. However, the saver would still be better off choosing this option as the amount paid in tax is significantly higher.

One option for savers who do opt to pay away is to place the interest payment within a separate savings account paying a similar rate of interest, which should make up the shortfall. As referenced, Paragon allows savers to do this directly into another account with the bank.

Does this impact savings held within a cash ISA?

No. Savers can put up to £20,000 a year into a cash ISA and any interest earned is tax free.

What other factors should savers consider?

A saver’s personal circumstances should be factored in when looking at the tax treatment of savings interest. For example, a saver may be a basic-rate taxpayer when a term account is opened, but their salary could increase during the course of the term, pushing them into a higher-rate tax band and, subsequently, the lower PSA threshold.

Visit Paragon's Savings Explained page to learn more about savings products.