Smart Money: The best ways to grow your savings free from paying income tax on the interest

Q I recently inherited my share of my parents’ estate, along with my two siblings. We each have around £100,000. I have just opened a one-year fixed rate account that would accept a large deposit, giving me the opportunity to have my money growing while I decide what to do with it over the longer term.My question is whether or not I should be preparing to pay income tax on this amount? And when would I need to pay it. I opened the account in January, and it pays 1.2 per cent annual equivalent rate (AER).

Isa tax-free accounts allow you to save £20,000 a year, and your savings will grow free from income tax. Picture: Adobe Stock

A I fully endorse your pragmatism here, and your resistance to rush a decision on using such a large amount of money. I fear you’ve missed a trick here, though, especially if you’re worried about tax.

Ideally, your first port of call would have been a cash individual savings account, or Isa. These tax free accounts allow you to save £20,000 a year, and your savings will grow free from income tax. As the end of this tax year is approaching in April, you would have been able to deposit £20,000 immediately and another £20,000 on April 6, shielding almost half of your inheritance from income tax within six months of receiving it.

Instead, you’re locked into a fixed term account for the next 11 months, which is not necessarily a bad thing, but means that you cannot free up the capital to use your Isa allowances until 2023. It’s worth checking the terms of the account to see if you can make any penalty-free withdrawals, but if you can’t and you attempt to take money out, you may face an interest penalty.

Let’s not dwell on the past. You’ve got a significant sum locked up paying a fairly decent rate at a time of low-interest rates. Over the course of the next 12 months, you’ll accumulate a neat £1,200 in interest.

The vast majority of savers enjoy a tax break on their savings called the ‘personal savings allowance’. Introduced in 2016, this allows you to earn up to £1,000 interest tax-free if you're a basic-rate (20 per cent) taxpayer, or £500 if you're a higher-rate (40 per cent) taxpayer. If you earn over £150,000 a year, making you an additional-rate taxpayer, you don’t benefit from the personal savings allowance.

Your £1,200 interest will be paid into your account ‘gross’, meaning that no tax will be deducted. But, depending on how much income you earn, £200 or £700 of that interest will be subject to tax.

If you’re a basic-rate taxpayer, meaning you earn less than £50,270 in the current tax year, you’ll pay 20 per cent on £200 interest – a total tax bill of £40. If you’re a higher-rate taxpayer, meaning you earn between £50,270 and £150,000, you’ll pay 40 per cent on £700, leaving you with a £280 tax bill.

Although income tax rates differ in Scotland, the UK rates and thresholds are used for savings interest.

The tax will likely be collected through the Pay As You Earn system, as your savings provider will give information about your interest to HM Revenue and Customs. You’ll be given a notice of coding to confirm this. Otherwise, you can declare the interest on a self-assessment tax return. You won’t need to declare this until you receive the interest in January 2023, so in your 2022/23 tax-return. The deadline to submit this and pay any tax owed will be January 31, 2024.

Jenny Ross is the editor of Which? Money