How does the Personal Savings Allowance work?

Under the PSA, basic-rate taxpayers can earn up to £1,000 in interest from their savings before they have to pay tax on them.

For higher-rate tax payers in the 40% tax band, this is lowered to £500.

Many savers will not come close to breaching the PSA, but any interest above the threshold must be reported to HMRC and is subject to tax.

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What is the PSA?

The introduction of the Personal Savings Allowance in April 2016 marked a significant change in how we pay tax on savings interest.

It means that:

• Basic-rate taxpayers can earn up to £1,000 in interest and it won't be taxed
• Higher-rate taxpayers can earn up to £500 in interest and it won't be taxed
• Additional rate taxpayers do not receive a PSA and must pay tax on all interest gained from savings held in places other than an ISA

All savings interest is now paid gross rather than being taxed as income before being paid to us.

However, it means that we have a responsibility to report and pay tax on any interest earned above our PSA at the end of each financial year.

How the PSA applies to savings

The personal tax-free allowance is renewed each tax year. It applies to interest earned with a range of accounts - from regular current and saving accounts to bonds and P2P lending.

ISAs are excluded as they're exempt from tax anyway.

It's worth pointing out that, while the limit with an ISA is on how much we can deposit each year, the limit with the PSA is on the returns.

We're not allowed to invest more than £20,000 net in an ISA over the course of the year - but the only limit on how much interest we can earn is the rate offered.

With a taxable savings account, however, once we've earned up to our PSA in interest, we must pay tax on the rest - 20% on interest earned above £1,000 for basic rate taxpayers, and 40% on anything above £500 in interest at the higher rate.

The best route for saving will vary depending on an individual's needs, how much they have available to save and how quickly they need access to it.

Even so, the key point to remember is that £1,000 of interest gained from our non-ISA savings is tax-free each financial year.

Staying within the PSA allowance

For many of us it may seem like there's nothing to worry about - because the chance of earning £1,000 in interest over the course of a year seems rather low.

The table below, for example, shows the interest we'd earn on a variety of balances, at a variety of rates.

Note that, for simplicity's sake, we've looked at average balances. That is, we're assuming that a saver puts their money into the account on day one of the financial year and leaves it there for the rest of the year - or that any withdrawals they make are balanced by deposits that maintain that average.

The amounts marked in bold are those that surpass one or other of the limits set for the PSA; it's clear to see that even with an account that pays an unusually high rate of interest, we need to have considerable average savings to make us liable to pay tax on it.

Importantly, however, the PSA applies to all of our taxable money, not just the funds we've earmarked as savings - including any interest earned by our everyday bank account.

So how much can we actually save before hitting our PSA?

Again, keeping it very simple and assuming an average balance over the course of the year, the table below shows the maximum that both a basic rate and higher rate taxpayer can save if all of their savings are earning interest at the same rate:

Bear in mind again that these figures cover all the money we have in all our taxable accounts - including those we use for day-to-day spending.

Yet the levels are still so high that typical savers won't get anywhere close to them. It's important to understand the thresholds, though, and perhaps consider seeking advice from a financial advisor if you're unsure about where your money should go and what liabilities you will have on it.

The case for ISAs

When the Personal Savings Allowance was introduced in 2016, it seemed to overshadow the ISA as the best way of saving.

ISAs were traditionally the best place to store savings and not pay tax on interest gained, but with a £1,000 tax-free interest threshold for basic-rate taxpayers, is there any benefit to putting money into an ISA?

While ISAs do offer poorer returns on savings, they're still useful - particularly for those who've been saving for a while, and those who pay tax at the higher rate, or think they may find themselves doing so in the near future.

For one thing, ISAs become more valuable over time - and no matter how valuable they become, they're never subject to tax.

For example, a saver who had deposited the full amount in cash ISAs every year since 2017/18 when the cap was increased to £20,000 per year would have deposited more than £100,000 by now - and their actual balance would be bolstered by years of interest paid tax-free.

Because ISAs are so well established, it's unlikely future Governments will alter their tax-free status.

They may also become more attractive to taxpayers if interest rates rise and we get closer to reaching our PSA limits, becoming liable for tax on any extra interest earned.

There is no suggestion yet that the ISA limit will be increased from £20,000 in the near future. However, past increases to the limit have been in line with inflation, so we could see increases if the high levels of inflation seen in 2022 persist.

While the ISA freeze has been described as a stealth tax by some critics, it remains the case that most of us are not going to be in a position where putting £20,000 in a tax-free ISA each year and holding enough money in other accounts to breach the £1,000 PSA limit is an issue.

Where to save

For those with money to save now, making use of the PSA makes sense - particularly when non-ISA interest rates are favourable.

But those who already have money in an ISA won't lose out by using keeping the money locked up - especially over the long-term.

Remember too, that money in ISAs can be moved to newer, better deals without losing the tax-free benefits - and as the interest rates on many savings accounts drops away over time, it can be wise to do so.

However, be careful when transferring from one ISA to another because a wrong move in the process could see the tax-free element of the savings pot eliminated permanently.

In an ideal world, savers would be able to invest in a high-interest easy access account up to a point close to their personal allowance then funnel the extra into an ISA.

For most normal people however, there's little worry about breaching the PSA. In this case, it's simply a matter of finding the account offering the best rate.

One final point: wherever we put our savings, it's crucial to know how they're protected.

Summary: Useful for savers

The Personal Savings Allowance was a quiet revolution in saving, ensuring we keep more of the interest from our savings without needing to go through the rigmarole of tax rebates from HMRC.

On the flip side, it does mean that big savers need to be aware of the PSA limit and ensure they pay tax on any interest accrued after that.

In reality, this won't affect many people and the people who are affected are likely to be taking financial advice from professionals.

Here are a couple of things to remember about the PSA:

• It means basic-rate taxpayers can earn up to £1,000 in interest on their savings before needing to pay tax on those earnings (this is lowered to £500 for high-rate taxpayers)
• We don't need to apply for the PSA - it's the standard for savings accounts
• At the end of the financial year, we may need to file a tax return if we've gone over the PSA limit and need to pay tax on earnings

Overall, the Personal Savings Allowance is a useful tool that allows savers to keep more of their interest earnings - certainly a welcome thing.