What are tax-free savings accounts?
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What is a tax-free savings account?
A tax-free savings account is a type of savings account that lets you earn interest on your savings without paying tax on the interest you earn. There are typically restrictions on this type of account, such as your annual income and how much you can save each year (more on that below).
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How do tax-free savings work?
In the UK, tax-free savings accounts allow you to earn interest tax-free if your annual income and savings interest is less than £18,500 in total.
ISAs, or individual savings accounts, are another type of tax-free savings account that anyone can apply for. With an ISA, you can save up to a maximum of £20,000 per tax year (normally 6th April to 5th April), and you can choose from a few different types of ISA.
In addition to dedicated tax-free savings accounts, you could also take advantage of a personal savings allowance (PSA) that allows you to earn up to certain amounts tax-free depending on your tax-banding.
What’s the starting savings rate?
You may have heard of the starting savings rate, which was created to help low-income earners on £17,500 per year or less save. The starting savings rate is a special 0% rate of tax on interest up to £5,000 (applicable to the 2020/21 tax year). This means you can earn up to £5,000 interest in your savings accounts completely tax-free.
Are there limits on tax-free savings?
Yes, tax-free savings accounts do come with some limits. Low-income earners who earn up to £17,500 a year are eligible for the starting savings rate. This includes your total personal allowance of £12,500, which is the amount you can earn before paying tax, plus the starting rate of £5,000.
As previously mentioned, the PSA allows anyone to earn a certain amount of money from their savings without paying tax, depending on their savings earnings and tax-banding. If you’re a basic-rate taxpayer, you can earn up to £1,000 in savings interest per year without paying tax on that interest, and higher-rate taxpayers can earn up to £500. This will increase your tax-free savings limit to £18,500, which includes your personal allowance (£12,500), starting savings rate (£5,000) and your personal savings allowance of £1,000.
There are some exemptions and differences, depending on your personal circumstances. For example, if you have a blind person’s allowance, your limit could be increased to £20,950. You might also be eligible for the married couple’s allowance.
What are the pros and cons of tax-free savings?
The main benefit of a tax-free savings account is, of course, that you won’t pay tax on the interest you earn from your savings. You’re also free to make withdrawals without incurring any penalties.
However, tax-free savings accounts in the UK typically offer less competitive interest rates than traditional savings accounts, and you could utilise your PSA to earn money from your savings without having to pay tax. It’s important to compare all the different types of savings accounts you’re eligible for, so you find the one that’s right for you and suits your savings goals.
Are there any better alternatives to tax-free savings accounts?
While there’s a possibility you may have to pay tax on your savings, it’s unlikely unless you earn between £500 and £1,000 in interest, depending on your tax bracket, and you’ll typically benefit from higher interest rates. It’s always important to compare savings accounts, so you get the right type of account with the best interest rate for you.
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