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Q: If you have a three-year cash bond which only pays interest at the end of the three year period, does all that interest become taxable in the year in which the bond matures?
Submitted via Which? Money Magazine.
A: When it comes to cash or savings bonds, you may need to pay tax on your interest if it’s more than a certain threshold. But the timing of your interest payments will determine when you need to pay – and how big the bill will be.
Which? explains how the personal savings allowance will apply to fixed-term cash bonds and how they compare to other savings products.
Personal savings allowance
Each taxpayer has a personal savings allowance which determines how much interest they can earn tax-free – in the 2016-2017 tax year, the allowance is £1,000 for a basic-rate payer and £500 for a higher-rate payer.
Interest is taxable in the year in which it is available to be drawn down, meaning the time when it’s made available to you.
So, if you have a three-year bond that is not accessible until the end of the term, all of the interest will be taxable in the final year.
On the other hand, if you had chosen to have the interest paid out annually to another account, it would be taxable on a yearly basis.
But you need to be careful – when your money is ‘available’ will depend on the bank’s terms and conditions.
The NS&I Guaranteed Growth bonds, for example, will allow you access your money before the term expires but deduct a penalty equal to 90 days’ interest. Because you can withdraw your money at any time, interest on these bonds are taxed on a yearly basis.
So, make sure you check the terms and conditions offered by your bank to find out whether tax will be incurred yearly, or at the end of the term.
- Find out more: personal savings allowance – how it works
Cash bonds pros and cons
Cash bonds are a good option if you want to make a higher return on your savings through interest – banks tend to offer higher rates in exchange for you committing to a longer timeframe.
But there are some drawbacks. If the interest you are receiving is less than the rate of inflation over the term, your original investment won’t be worth as much when you get the money back.
What’s more, if you need to access your money before the fixed term ends, you may have to pay a penalty for making an early withdrawal, or simply won’t be allowed to access any of your capital. Most bonds have a fixed term between six months and five years.
There are also some risks involved. While cash put into UK banks or building societies is protected by the Financial Services Compensation Scheme (FSCS), this is only up to £85,000 for each individual per firm.
If the total of all of your investments with a particular bank exceeds £85,000, even spread across separate accounts, you will not be covered on the excess. So, it’s worth using more than one firm and watching out for two different brands that share a banking licence, such as Yorkshire Bank and Clydesdale Bank.
- Find out more: what are the different savings accounts?
Invest with gilts and corporate bonds
If you’re willing to accept more risk in exchange for more potential gain, gilts and corporate bonds are an option.
Gilts are bonds issued by the British government to fund public spending. Essentially, you lend money to government. Some gilts pay interest linked to the the Retail Prices Index (RPI), meaning the interest you receive will rise in line with inflation.
Other governments also issue bonds. These can carry different risks depending the stability of each government’s economy, and whether the interest is paid in pounds or another currency, which might be affected by exchange rate drops.
Corporate bonds involve lending to a company, rather than a government. Again, the risk involved depends on the stability of the company, so it can vary.
If you buy funds that invest in gilts or other bonds, the income you receive from the fund will also be treated as savings income. If you choose funds that invest in equities, then the income you receive will count as dividend income, which is taxed differently.
- Find out more: Gilts and corporate bonds explained
Win big with premium bonds
For some tax-free winnnings, you could consider premium bonds. Instead of paying out interest, all premium bonds are instead entered into a monthly prize draw, with the winners selected at random by National Savings & Investments.
The prizes are between £25 and £1m. All winnings are tax-free, and NS&I is backed by the treasury, so your investments are safe. However, you can only invest up to £50,000 in total, and the prizes are a lottery, so there is a chance you could win nothing.
As our graph shows, the number of prizes are on the increase each month.
Save tax-free with an Isa
You could also consider an Isa – another low risk, tax-free option to grow your savings.
The annual allowance for money that savers can store in Isas is currently £20,000. Your allowance goes back to zero at the beginning of the tax year – so you have until 5 April to take advantage of the full amount, before the 2018/19 tax year begins on 6 April.
There are several types of Isas available, each offering interest on your savings. Cash Isas work like normal savings accounts, except the interest is always paid tax free. And you can hold gilts, or other bonds within an investment Isa, which means you won’t owe any tax on that either. For more, read our guide on how to find the best cash Isa.