HM Revenue & Customs issue guidance on the 10% starting rate for ‘savings income’

Following the announcement in the 2007 Budget, with effect from 6 April this year the 10% starting rate of income tax was abolished on earnings, whilst being retained on savings income and capital gains.

There has been widespread confusion about exactly how the 10% starting rate for ‘savings income’ will work given that most people’s income comprises both earned income (e.g. wages and pensions) and savings income (e.g. bank and building society interest). Therefore last week HM Revenue & Customs (HMRC) issued guidance and examples to clarify the matter.

The guidance omits to mention that the starting rate is also applicable for capital gains, but it is understood that the mechanics will work in exactly the same way as for savings income.

Summary of the HMRC guidance (using 2008/09 rates and allowances).

Almost everyone is entitled to a personal allowance, which allows them a certain amount of income that does not get taxed. If an individual’s total taxable income (both earnings and savings) is more than their personal allowance, they will have to pay tax on the income that is above their allowance. The amount of an individual’s personal allowance increases with age, but the basic personal allowance is £5,435.

The rate of income tax varies between 10%, 20% and 40% depending on the type of income received (earnings or savings) and how much of each type of income is received.

Most taxable income (up to the basic rate limit of £36,000) is taxed at the basic rate of 20%, but there is a special 10% starting rate for savings income that an individual may be entitled to. The rate at which an individual’s saving income is taxable will depend on how much earnings they receive. If an individual’s earnings are less than their personal allowance plus £2,320, then some or all of the individual’s savings income will be taxable at 10%.

If an individual’s only taxable income is savings income they are entitled to have the first £2,320 of income above their personal allowance taxed at 10%, with any savings income above £2,320 taxed at 20%.

Banks and building societies will automatically deduct tax at a rate of 20% from the interest an individual earns. So if an individual is entitled to have any savings income taxed at 10% they will be able to claim some tax back from HMRC.

Example A – No earned income

Hector has no earnings at all, but he does have savings income of £10,000. Hector’s personal allowance is £5,435 because he is under 65. Hector’s taxable income is therefore £4,565 (£10,000 - £5,435).

The first £2,320 of taxable income is taxed at the special starting rate for savings of 10% and the rest is taxed at 20%. The calculation below shows how this is worked out
£2,320 x 10% £232
£2,245 (4,565 – 2,320) x 20% £449
Total Tax £681

Because Hector’s bank will have taken tax off all of his interest at 20% Hector will be due a repayment of £1,319 ((£10,000 x 20%) - £681) which he will need to claim from HMRC.

Example B – Earned income below personal allowance

Lynn has earnings of £4,000 and savings income of £6,000. Lynn’s personal allowance is £5,435 because she is under 65. Lynn’s taxable income is therefore £4,565 ((£4,000 + £6,000) - £5,435).

Lynn’s personal allowance is firstly used against her earnings of £4,000 so none of her earnings are taxable. All of Lynn’s taxable income is savings income.

The first £2,320 of taxable income is taxed at the special starting rate for savings of 10% and the rest is taxed at 20% . The calculation below shows how this is worked out.

£2,320 x 10% £232
£2,245 (4,565 – 2,320) x 20% £449
Total Tax £681

Because Lynn’s bank will have taken tax off all of her interest at 20% Lynn will be due a repayment of £519 ((£6,000 x 20%) - £681) which she will need to claim from HMRC.

Example C – Earned income above personal allowance and starting rate limit for savings exceeded

Deryn has earnings of £20,000 and savings income of £5,000. Deryn’s personal allowance is £5,435 because she is under 65. Deryn’s taxable income is therefore £19,565 ((£20,000 + £5,000) - £5,435).

After taking the personal allowance off her earnings, the amount of earnings that is taxable is more than £2,320 (£20,000 - £5,435 = £14,565) so none of her savings income is taxed at 10%. All of her income is taxed at 20%.

Example D – Earned income above personal allowance but does not exceed starting rate limit for savings

Fernando has earnings of £6,000 and savings income of £4,000. Fernando’s personal allowance is £5,435 because he is under 65. Fernando’s taxable income is therefore £4,565 ((£6,000 + 4,000) - £5,435).

Fernando’s personal allowance is all used against his earnings of £6,000 so only £565 (£6,000 - £5,435) is taxable. The rest of the starting rate limit of £1,755 (£2,320 – £565) can be used against savings income. The calculation below shows how this is worked out. Fernando’s earnings must be taxed before his savings.

Earnings £565 x 20% £113.00
Savings £1,755 x 10% £175.50
Savings £2,245 (£4,000 – £1,755) x 20% £449.00
Total tax £737.50

Fernando’s bank will have taken tax off all of his interest at 20% so they will have taken off £800 (£4,000 x 20%). But Fernando is only due to pay £737.50 tax. This means he can claim a repayment of tax from HMRC of £62.50 (£800 - £737.50).

If you would like further details on how the abolition of the starting rate on earnings will affect you or how you can claim a repayment from HMRC please speak to your usual Hazlewoods tax contact or click here (link to standard query e-mail please)