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Buying a house is undoubtedly one of the most stressful - not to mention expensive - things you can do, especially in 2023.Ìý

With mortgage rates rising at a staggering rate and house prices starting to fall, the uncertainty in the housing market is rife.Ìý

However, people still want to buy a place of their own. Homebuyers have spent the past few years being frugal and saving up every penny until they can get their dream home.Ìý

Good for them - this lump sum should be celebrated in a savings account!

But - and it’s a big but - there’s a catch.Ìý

Rising interest rates don’t just affect mortgages, after all, they also boost returns on your savings. But, if your savings are in the wrong sort of account, you could be about to pay tax on them.

How savings are taxed

This was something we haven't had to worry about for a long time, thanks to a combination of low interest rates and something called the Personal Savings Allowance (PSA).

The PSA means basic-rate taxpayers can earn up to £1,000 in interest before being taxed on any of it. Alternatively, if you are a higher-rate taxpayer this allowance is slightly smaller at £500.

There is also the starting savings rate for people who are on an income below £12,570, as they can benefit from a £5,000 starting savings allowance and the PSA of £1,000 tax-free - but that's another story.

Low interest rates meant it took vast sums in the bank to even worry about tax over the past few years. But it’s a different story today as some fixed-rate accounts are offering more than 6% interest.Ìý

In January 2022 when the average interest rate for a one-year fixed rate bond was 0.71%, a basic-rate taxpayer would have needed around £140,000 to have been hit with the tax.Ìý

But today, the top interest rate for a one-year fixed rate bond is 6.1%, so if a basic-rate taxpayer has £17,000 in this fixed account, the interest will be taxed. For a high-rate taxpayer you would only need a mere £9,000 in this savings account for the tax threshold.

And, when you factor in that the average first-time buyer deposit is £61,000, that puts into perspective how many people might have a lump sum of money that is taxable.Ìý

How taxes affect your savings rates

So, what does this mean for your savings? 

Well, first of all, it’s important to not become completely attached to whoever’s paying the highest rate - regardless of the type of accounts.

That’s because the savings account with the highest interest rate isn’t always the best option for you, as the PSA means that once you become taxed, the interest rate effectively drops.Ìý

Let’s break that down and go back to our old friend, the one-year fixed-rate bond.Ìý

If you had £20,000 in savings, you would earn £1,220 in interest in one year if the interest rate was 6.1%, but this would then become taxed as you’ve gone over the allowance.Ìý

You pay tax at the same rate as income tax, which is 20% for most people, so £44 would be deducted from that £1,220 interest. If you are a higher-rate taxpayer than the 20% becomes 40% and you’re taxed after £500 of interest, meaning £288 is deducted.Ìý

That drops the effective interest rate you’re earning from 6.1% to 4.66% for a higher-rate taxpayer, or 5.88% if you’re a basic-rate taxpayer.

And the more you have saved up, the lower your effective interest rate becomes.

The savings accounts that are never taxed

The good news is that any savings in a lifetime ISA or a Help to Buy ISA are protected from tax.

But, if you have savings elsewhere and don't want to be taxed, you can shift up to £20,000 a year each into an old friend - the cash ISA.Ìý

We’ve had a turbulent relationship with ISAs over the years, as with interest rates so low, its main appeal of tax-free savings has felt worthless.

That is, until now.Ìý

An ISA could now be the best place for your money if you are saving to buy a house. This is because you won’t be taxed on your savings if you use your allowance of up to £20,000 each year.

The good news is that interest rates on ISAs have also been rising, with a 1-year fixed-rate ISA reaching 5.5%. So, if we take our £20,000 again does this mean we’ll be better off? 

In a cash ISA with an interest rate of 5.5%, you would earn £1,100 in interest with no deductions. But, with the fixed-rate bond mentioned above you would earn £1,176 unless you’re a higher-rate taxpayer.Ìý

In this instance, a fixed-rate bond is still the best option, but this would change if you had a larger sum of money. The greater amount saved, the more interest you would earn, and then a sizeable chunk of tax is lost.Ìý 

So, let’s say you’ve saved £40,000 with your other half (both basic tax-payers) and you want to move it to a one-year fixed-rate bond because you won’t be moving until 2024. At 6.1%, you’ll earn £2,440 in interest after one year, but you’ll have £288 deducted, giving you a total interest pot of £2,152.Ìý

Instead, if you put £20,000 in a cash ISA at 5.5% and so did your partner, you wouldn’t have any tax deducted and would earn £2,200 in total, which is £48 more than the fixed-rate bond.Ìý

Therefore, it’s always important to compare all savings accounts if you have a lump sum of money saved and factor in tax when you are deciding how much interest you can earn.Ìý

This will mean you have as much money as possible when you do decide to buy that dream home.