Elevated inflation and rising interest rates are forcing (some) banks to put a bit of effort into fighting for our cash. Average rates on an easy-access savings account are nearly 15 times higher than they were 12 months ago, and even the UK's National Savings & Investments (NS&I) has got in on the act.
NS&I announced two increases to its Premium Bond prize rate in the last two weeks of June: bumping up the rate in July to a 15-year high of 3.7 per cent and, from August, the prize rate will be 4 per cent. It then subsequently upped the rate on its one-year Guaranteed Growth and Income bonds to 5 per cent.
Now, of course, usual caveats apply when discussing Premium Bonds: namely that those rates aren’t guaranteed. They’re based on the probability of winning a prize. You could earn a lot more or win nothing at all. But for those who are set on putting money away, it sets up an interesting dilemma for those with substantial savings, and high earners.
The issue comes down to tax. The average easy-access savings account pays 2.53 per cent interest, according to Moneyfacts, but there is a wide spread. The best-paying account pays 4.22 per cent, and this means that anyone with more than £23,700 stashed away will face a tax bill due to the personal savings allowance, which kicks in when interest on savings reaches £1,000 a year. For higher-rate taxpayers, the allowance is £500, meaning any savings above £11,800 will fall foul (additional rate payers have no allowance at all).
It’s becoming an issue. A higher-rate taxpayer with the best-paying one-year bond will only be able to save around £8,200 before returns are taxed at 40 per cent – taking a 4 per cent interest rate down to 2.4 per cent. This will only get worse as rates keep on rising. Current market expectations are for the Bank of England rate to hit 6.5 per cent next year, so there’s a lot of room for savings rates to rise further, too – and for savings in excess of personal allowances to be taxed at savers' marginal rate of income tax.
There are of course ways to avoid this. Savers can use a cash individual savings account (Isa), but one must consider whether it’s wise to use the £20,000 annual allowance on cash rather than shares. The other is of course NS&I, whose Premium Bond prizes are tax free (NS&I’s other non-Isa accounts all attract income tax subject to the same aforementioned allowances).
But here lies the dilemma, Premium Bonds act almost as a base for savings rates, and will hardly ever be a best-buy. NS&I rates are governed by its mandate to be competitive, while simultaneously not damaging competition. It must also account for its funding targets set by the Treasury. The bonds were a best-buy earlier in the year, but this was short-lived as commercial operators, earning more from higher mortgage rates, were forced to compete for savers’ attention. By the time NS&I hits 4 per cent next month, the current best buy of 4.22 per cent will likely have moved much further on.
So savers caught out by the tax trap have a decision to make. Higher guaranteed interest, but returns eaten away by tax, or decent hypothetical returns from NS&I with no tax bill and the chance of winning as much as £1m – but also the potential to receive nothing whatsoever. One way would be to run a split strategy, for those who can manage the admin, placing enough in high-paying accounts to remain tax-free, and the rest in Premium Bonds. More money in the latter increases your odds of winning, but there is a £50,000 limit.
What all this proves is savers need to remain active and vigilant in managing their cash piles. Rates are running much higher than they were, so the problem is a nice one to have. But cash accounts aren't a long-term strategy, particularly as none of the rates on offer match up to inflation.
