The experts said the HMRC system has many ‘outdated’ rules
Tax experts have warned that a counterintuitive tax rule highlighted by Martin Lewis is affecting ever more people. Their comments come after Martin Lewis, founder of MoneySavingExpert, posted a video where he exposed the “hole in the tax system” whereby you can take home more money by earning less interest on your savings. The financial journalist labelled the rule that relates to income tax and the tax-fee allowances on savings as “bizarre” and “totally bonkers”. Mr Lewis said: “It all starts because the rate at which you pay higher rate [income] tax is £50,270. For each £1 you earn after that the tax increases from 20 percent to 40 percent so you only take home 60p.
“But at the same time, your Personal Savings Allowance, the amount you can earn from savings outside of an ISA each year, drops from £1,000 a year tax free to £500 a year of interest tax free. And that is what causes this hole.”
READ MORE: ‘I tried Martin Lewis’ secret radiator trick, it boosts heat and slashes bills’
He gave the example of a person earning £49,300 from their job who earns £1,000 a year in savings interest, meaning their total earnings are £50,300.
As their total income is above the higher rate threshold, only £500 of their interest earnings would be tax-free. The rest of their interest would be partly taxed at 20 percent and partly at 40 percent, so they would take home £894.
In contrast, a person also earning £49,300 through their employment, but with just £950 in interest earnings, would have a total income of £50,250, just £20 below the higher rate threshold.
‘Totally bonkers’
As a basic rate taxpayer, they still have the £1,000 savings allowance and so would keep all £950 of their interest earnings. Mr Lewis said: “It’s totally bonkers – it should not work like that, but it does work like that.
“It is one of the very few points in the income tax system where if you earn more, you take home less.” Tax experts have spoken out to criticise the strange way the rules work.
Aaron Peake, personal finance expert at free credit score service CredAbility, said: “The issue Martin Lewis has spoken about shows how unnecessarily complicated our tax system has become. The fact that some people can earn more by getting less interest is counterintuitive.”
Yet he warned the little-known rule comes into play more often people realise. Mr Peake said: “This quirk is not as rare as people think.
“There are around 28 million basic rate taxpayers in the UK, and with interest rates rising, more people are earning enough interest for this to matter. Many savers still believe all their interest is tax-free, but that’s not always the case.
“The problem is that savings income isn’t automatically taxed at source for everyone. Banks report it to HMRC, but unless people check their tax code or self-assessment details carefully, they might not spot errors or overpayments. With so many people now juggling multiple savings accounts, it’s very easy to lose track.”
READ MORE: HMRC explains £6,000 tax rule for selling items on eBay
Gerard Boon, managing director of Boon Brokers, also said the tax system is far too complex and confusing for people. He said: “The fact that a small change in someone’s income can trigger a disproportionately higher tax on their savings shows just how disconnected and inconsistent the system has become.”
He said the HMRC system is “full of holes and outdated procedures” with “half-forgotten rules that only a select few know how to find or interpret”. Mr Boon said the system should be more transparent and predictable.
How could the tax system be improved?
Mr Peake said the Government should look at merging the savings starting rate and the personal savings allowance into one threshold to make the system fairer. The savings starter rate allows you to earn £5,000 in interest tax-free, but this is reduced by £1 for each £1 you earn above the personal allowance. This allowance means you can earn £12,570 without paying income tax. So once your income have reached £17,250, your starters rate is reduced to zero.
Explaining how merging the starter rate and the personal allowance would make life simpler, Mr Peake said: “That way, savers would know exactly how much interest they can earn tax-free, regardless of how their income is made up.
“Another option would be to taper the allowance gradually, instead of having it disappear completely once someone earns over a certain limit.” Mr Boon also called for the system to be made easier to navigate.
He said: “Simplifying tax on savings and income would go a long way toward restoring public trust. A fairer system could align thresholds, smooth out punitive cliff edges, and remove the bizarre inconsistencies that make people worse off for earning slightly more.
“In the end, an economy thrives not when people are forced to outsmart the system, but when the system works clearly, efficiently, and without favour.” The Treasury has been approached for comment.
