What is the Personal Savings Allowance?

In any question about savings and taxation you will likely find a reference to the Personal Savings Allowance (PSA), which was introduced in 2016 – but what is it? Simply speaking, the PSA allows you to earn up to £1,000 in interest each year without paying tax on it, with the level you get determined by your tax status.

Basic rate (20%) taxpayers get the full Personal Savings Allowance of £1,000, while higher rate (40%) taxpayers can earn up to £500 in interest tax-free and additional rate (45%) taxpayers don't get an allowance.

Savings income for the purposes of the PSA includes any interest you accumulate from bank and building society accounts – via savings and current accounts – as well as any savings with credit unions and the NS&I (with the exception of their tax-free accounts), any income from bonds, and interest from certain trusts, open-ended investment companies, trust funds, peer-to-peer lending, some life insurance contracts and most types of purchased life annuity payments. Naturally, ISAs are not included, as they are already tax-free. 

Note that for those with joint accounts, any interest is split equally between the two account holders for tax purposes.

The vast majority of taxpayers will currently not have to worry about breaching the PSA limit – especially given the current state of savings rates. If you go over the limit you just need to declare the extra interest to HMRC. 

Any tax you would have to pay will depend on your tax-free Personal Allowance, tax band and the starting rate for savings. If you’re unsure or feel you are being unfairly taxed, you may want to seek professional advice.

Many people could be questioning if they still need a cash ISA when the interest they earn in any other account is tax-free, too. Cash ISA returns aren’t helping with this matter, either, as they have been lagging behind non-ISA rates ever since the PSA was introduced. However, there are still reasons to put at least part of your savings into an ISA.

For one, there's no guarantee that the PSA will last forever. This means that, if it were to be withdrawn in future, all of your savings held in non-ISA accounts would become liable for tax again – and you'd only be able to transfer a small portion of it into an ISA to shield it. This isn't the case with ISAs, where everything you save should be tax-free for life.

Then there's the fact that interest earned from an ISA doesn't count towards your PSA, so if you're lucky enough to already have a big enough savings pot that would mean you hit your limit, you can still save in an ISA for more tax-free benefits. An ISA isn't dependent on tax status, either, so if you were to become a higher or additional rate tax-payer in the future, you wouldn't lose out on tax efficiency.

And what if savings rates rise? The current landscape means you'd need a hefty savings pot before you’d start paying tax, but if rates were to increase, your tax-free savings potential would diminish. For example: today's rates may be around the 2% mark (see the top savings rates for returns that can beat this), but if they were to rise to 4%, anything above £25,000 would become liable for tax among basic rate taxpayers – and if rates went even higher, such as on fixed rate bonds, you could save even less.

Essentially, this means that you shouldn't turn your back on ISAs just yet, because they still offer valuable, long-term tax efficiency. Nonetheless, the Personal Savings Allowance remains a huge boon for savers, giving them the chance to earn tax-free interest across a range of savings, banking and investment products.