Fixed-term savings products – such as three-year or five-year bonds – can be appealing as they offer attractive rates of interest to savers willing to tie up their money for a while.

However, if you have one of these products or you’re considering taking one out, you need to look carefully at the terms of the account to see when your interest will be paid.

If interest is earned when the bond matures at the end of the fixed period, rather than annually, you could end up exceeding your new annual Personal Savings Allowance in the final year and be left with an unexpected tax bill.

Here, we explain more…

What is the Personal Savings Allowance?

The Personal Savings Allowance (PSA) came into force on 6 April 2016 and it means around 95% of taxpayers won’t pay any tax on their savings income, such as interest.

Savings in ISAs aren’t impacted.

Here’s how it works:

• Basic rate taxpayers (20%): those who earn up to £43,000 will be able to earn up to £1,000 interest without paying any tax on it
• Higher rate taxpayers (40%): those who earn between £43,001 and £150,000 will get a £500 tax-free savings allowance
• Additional rate taxpayers (45%): those who earn above £150,000 aren’t eligible for the allowance.

Banks and building societies now no longer deduct income tax from interest earned and instead feed information to HM Revenue & Customs (HMRC).

HMRC will then adjust your PAYE tax code in case you exceed your PSA, so any tax owed should be automatically collected in the following tax year.

If you’re self-employed, you’ll need to include savings interest information in your tax return.

So what’s the problem with fixed-term products?

While the PSA lets you earn up to £1,000 (or £500) without paying any tax, you could exceed your PSA limit without realising if you have a fixed-term product, depending on when the savings interest is earned.

Brian Brown, head of insight for banking and general insurance at independent financial researcher firm, Defaqto, says you could breach the limit without physically getting access to the cash.

He says: “For accounts which have a fixed term and where the money can’t be withdrawn before the end of the term, there is a view that the interest is not ‘earned’ until the end of the term is reached. In fact, many lenders actually credit the interest to the account annually, or even monthly, even though you can’t withdraw the money until the end of the term.”

Depending on whether you’re a basic or higher rate taxpayer, the savings you hold and when interest is deemed to have been ‘earned’, it could mean you’re making more than £1,000 a year (or £500) in savings interest and so you will need to pay tax on any amount above this.

Brown says customers have to think very carefully about their choice of longer-term savings products and the tax years into which their earned interest will fall, if they want to optimise their PSA.

Generally, if you’re a basic rate taxpayer or a pensioner with higher levels of savings, or you’re a higher rate taxpayer with large savings, it may be best to choose a product where interest is credited to the account annually but paid out at maturity, rather than it being credited and paid out at maturity only.

Here’s an example of how taxpayers may be affected:

When choosing a fixed-term product, Brown says savers should look at these four particular points:

1. When interest is paid to your account
2. The likely amount of interest each tax year
3. The likely amount of interest at maturity
4. Your likely tax band in each tax year and at maturity

Savers shouldn’t dismiss ISAs

Anna Bowes, director at Savingschampion.co.uk, says with the new PSA, some people will need to pay tax in advance of interest they are yet to receive if they choose to have interest credited monthly or annually before the fixed-term product matures.

As an example, the three-year Pensioner Bonds offered through NS&I allows the customer to access the interest to spend at the end of the term, but it’s credited into the account and compounded each year so it’s deemed to have been credited.

In contrast, a longer-term savings product with Yorkshire Building Society (YBS) is capitalised annually, but for tax purposes, it is capitalised on maturity, Bowes says.

She adds that those likely to go over their PSA “shouldn’t dismiss ISAs” as “they have a real place” in the market for savers as they don’t need to worry about tax or when interest is credited to their accounts.

“Unfortunately, the counter argument is that interest rates on cash ISAs has been going down so now there’s a big different between cash ISA rates and those offered in normal savings accounts.”

However, she notes that Bank of England statistics show that deposits into cash ISAs have increased month-on-month since July 2014, while money held in notice accounts and bonds has actually decreased since April 2014 – apart from a slight uptick in February 2016.

What does HMRC say?

An HMRC spokesperson says it’s all about availability and has nothing to do with whether the saver actually accesses the savings.

“In general, interest counts towards a saver’s PSA when it ‘arises’ – that is when it is received, or made available to the recipient. Interest has been made available if it is credited to an account on which the account holder is free to draw.”

He clarified that if the account holder is unable to access the interest it will not count towards their PSA for that year. If, however, they are able to access the interest then it will count towards their PSA for the year. So even if the account has a penalty for early access, you could still be hit.

“The exact position will depend upon the terms and conditions of the account and what is meant by not having access to interest that has been paid,” he adds.