Boost tax-free Personal Allowance for savings with HMRC pension rule | Personal Finance | Finance

It’s a big problem for more and more workers as tax thresholds stay frozen in place but earnings gradually increase.

After being frozen since 2021, the tax thresholds are set to stay stuck at the same levels all the way until 2031.

For people who work and also have savings, this presents another problem – losing more of your savings to interest as you break through the tax-free Personal Savings Allowance limits.

Under current HMRC rules, anyone earning up to £50,270 can earn £1,000 of interest tax-free in what is known as the Personal Savings Allowance.

It means that you are able to earn £1,000 interest paid to you from you bank account without owing HMRC any tax money on it. Then, every £1 of interest you make over that £1,000 is taxed at 20%.

However, if you earn over £50,270 in a single tax year, including from property income and side hustles as well as your main income, your tax-free Personal Savings Allowance is slashed in half, to just £500. For those earning over £125,140, you get no savings allowance at all and have to pay tax on all interest generated by savings.

Thanks to ‘fiscal drag’, more and more people will end up paying tax on savings as wages increase to account for inflation but the thresholds stay fixed in place.

As explained by Money Week: “Consider a saver who had £49,500 in salary and £500 in savings income last year. She was just below the £50,270 higher-rate tax band and paid basic-rate tax.

“Let’s say, this year, her interest rises to £1,500. This means she has £51,000 in total income, which pushes her into the higher-rate tax threshold and reduces her personal savings allowance to £500.”

However, there are two key ways to avoid this. Of course, you can put money in a Cash ISA, which allows tax-free savings deposits of up to £20,000 per tax year on top of your £500 to £1,000 Personal Savings Allowance, with all the interest also tax-free.

Or, if you’ve already maxed out your ISA allowance, one this or you need to keep money outside of an ISA, for example if you’re about to complete a large purchase, then you can use one other HMRC rule around pensions to avoid crossing the threshold.

Pension contributions are tax-free. It means you can save money into a workplace pension at the point of payment and avoid losing any of the money to tax. But it also allows you to lower your taxable income to below the threshold at which your Personal Savings Allowance would be cut.

For example, if you earned £53,000 a year, you would only be allowed to gain £500 of tax-free interest on savings.

But if you put £167 per month into your workplace pension (£2,000 a year), this would lower your earnings down to £51,000 and you would benefit from the full £1,000 Personal Savings Allowance.

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HMRC says about the Personal Savings Allowance: “You may…get up to £1,000 of interest and not have to pay tax on it, depending on which Income Tax band you’re in. This is your Personal Savings Allowance.

“Your allowance applies to interest from:

“You pay tax on any interest over your allowance at your usual rate of Income Tax.”