Compound Interest & The Taxman

dogun

Hi all, 

I have what might end up being a basic question, but can't find an answer anywhere. 

When calculating savings interest earned in a year, does the taxman factor in interest earned on interest ie compound interest? Chip's easy access account pays interest monthly and this could mean at the end of the year, interest earned takes me over my tax free allowance (IF it factors interest earned on monthly interest). 

My immediate thought is, as far as the taxman is concerned, interest is interest and they'll consider anything above the limit. 

I'll be opening an ISA anyway to be on the safe side, but would be good to know the answer anyway. 

wmb194

dogun said:

Hi all, 

I have what might end up being a basic question, but can't find an answer anywhere. 

When calculating savings interest earned in a year, does the taxman factor in interest earned on interest ie compound interest? Chip's easy access account pays interest monthly and this could mean at the end of the year, interest earned takes me over my tax free allowance (IF it factors interest earned on monthly interest). 

My immediate thought is, as far as the taxman is concerned, interest is interest and they'll consider anything above the limit. 

I'll be opening an ISA anyway to be on the safe side, but would be good to know the answer anyway. 

You simply report the interest that's been paid to you for the tax year in question. If you anticipate the effect of compounding to take you over your 0% allowance then the answer to your question is yes. 

You can try to mitigate this, though, by, for instance, depositing your money in an account* that will make its next interest payment in the next tax year.

*Or an interest bearing security e.g., a gilt or corporate bond.

PloughmansLunch

Off-topic, but the thread title is a great name for a band

cwep2

HMRC considers interest earned *only* at the point you get paid interest.

A couple of examples:
1yr fix paid at maturity taken out 15th April 2022 (say £10k @ 5%) will pay £500 interest on 15th April 2023. For HMRC all £500 of this is part of your 2023-24 income and goes on your 2023-24 Tax return (for tax year 6Apr23-5Apr24) even though 97% of it was earned in the previous tax year.

Instant access savings account which has option to pay interest monthly at 3.15% gross (3.20% APR) or annually at 3.20% taken out on 15th April 2022 (paying on 15th of each month for monthly interest or on anniversary for annual) with £10k initial balance. For monthly account this would pay around £25-28 interest each month (rising slightly as balance increases and varying due to #days in the month) and 11 of these payments would count as interest earned in the 2022-23 tax year and 12th would count as interest earned in the 2023-24 tax year; for the annual account this would pay £320 in one payment on 15th April 2023 and all of this would count as being earned in the 2023-24 tax year.

Note in the second example, you can 'manage' your interest slightly for accounts that pay annually to fit within certain tax years by closing them early (in the previous tax year, in this example say in March 2023) and they will normally then pay all the interest earned up to the point you closed the account. A lot of people were doing this with interest rates rising so interest income in 2023-24 was likely for those with savings to be much higher than 2022-23 which started the tax year with instant access rates around 1.5%. Only works really for annual interest accounts which mature 'early' in the following tax year and where your marginal rate on interest income will be lower in the earlier tax year. 

ColdIron

Interest is interest, it doesn't matter how it arises

cwep2

And yes interest on interest (for accounts paying monthly) will mean that the amount you earn monthly at the end of the year will increase. But the Chip APR of 3.82% actually means a "gross" monthly interest rate of 3.75%.

So on £10k you get £10,000 * 0.0375 * 30/365 = £30.82 for a 30 day first month. After 11 monthly payments the balance will be approx £10,350 and the final interest payment will be around £32 leaving you with roughly £10,382. So over the year you've earned £382 on £10k which is an APR of 3.82%.

Almost all savings rates are quoted primarily in APR (and they all have to show the APR) to mean you can compare them easily. This is how monthly compounding of a gross rate of 3.75% gives an APR of 3.82%. The difference is around 0.07% at these levels. 

auser99

Trying to think of any reason why they WOULDN'T consider compounded interest as interest?

Albermarle

HMRC considers interest earned *only* at the point you get paid interest

Regarding fixed term accounts longer than one year ( two, three, five years etc ), there have been a number of threads on when the interest is accounted for by HMRC.

It is less than 100% clear, but it seems that the HMRC rule is as you say. That the full interest will be taken into account in the tax year it is due.

However some providers report the interest annually ( even though you can not get your hands on it) and then HMRC appear to  take it into account for that tax year. Seemingly against their own rules. Possibly because it is easier just to use the reported interest and not query every account.

It is a grey area at best.