NB: The rates of return quoted are accurate on the date of this blog post’s publication.
We’ve been talking a lot about the new Innovative Finance ISA (IFISA) on this blog in recent weeks – and with good reason, given the tax benefits it will offer to peer-to-peer lenders once it is launched in April.
But there is another reform to the UK’s tax system due at the start of the new financial year that also merits some attention. This is the launch of the Personal Savings Allowance (PSA), which was first announced by George Osborne in his Budget last March.
What is the PSA?
The PSA will instantly remove the obligation for millions of savers (not to mention P2P lenders) to pay tax on the interest they earn by providing everyone with an annual tax-free allowance of £1,000 (or £500 for those who pay income tax at 40%).
For basic-rate taxpayers, this means that unless their annual income from interest on non-ISA accounts or P2P loans exceeds £1,000, they won’t be taxed on it. And banks, building societies and other financial companies – including Zopa – will no longer automatically deduct 20% tax from the interest payments they make.
With interest rates on savings accounts at particularly low levels at the moment, only people with relatively large bank deposits will face any tax bills once the PSA is introduced.
The PSA in action
At 1.5% interest, for example, you would need to have almost £70,000 in your account to generate more than £1,000 interest in a 12-month period. (Bear in mind, though, that the PSA applies across all the accounts you hold and all the interest received – you don’t get a £1,000 allowance on each account.)
For Zopa lenders receiving an average annual return of 5%, those who have advanced more than £20,000 (or £10,000 for higher-rate taxpayers) will have to pay some amount of income tax. But a large number of Zopa customers will be able to lend tax-free, and the vast majority will benefit in some way from the change.
How can the PSA and the IFISA work together?
Lenders need to bear in mind that, when money is put into any kind of ISA, it is free of tax permanently. This means that, over the years, a large savings or loan pot can be built up without any income tax becoming due.
For example, if you managed to lend the full IFISA allowance of £15,240 a year for five years at 5% a year, you’d end up with over £85,000 (this assumes you lend £1,270 a month for 60 months).
By this point, your annual interest receipts would be £4,250, most of which would be taxable if the loans were hold outside an ISA.
Using your ISA allowance doesn’t cost anything so, as this example shows, it makes sense to take advantage of this first – especially if you are putting money aside for the medium or long term. Your PSA can then be used as a backstop to shelter the bulk of any further loans or savings from the taxman if necessary.