Pensioners account for nearly half of taxpayers hit by cash savings tax trap

Pensioners account for almost half (44%) of all taxpayers facing an HMRC bill for interest earned on their cash savings, new data obtained by AJ Bell shows.

A freedom of information request from the investment platform shows HMRC expects 1,160,000 people over state pension age to incur an income tax liability on savings this tax year (2025/26).

It means that pensioners account for almost half of the 2,640,000 taxpayers due to pay income tax on cash savings interest earned in the current financial year.

Among basic rate taxpayers, pensioners account for almost two-thirds of those with a savings income tax liability, indicating lower income pensioner households are particularly susceptible to the tax grab.

The total number of taxpayers incurring tax on savings has spiralled in recent years, courtesy of a combination of rising interest rates and frozen tax thresholds. This includes the personal savings allowance for interest, which has been frozen since it was introduced almost a decade ago.

While self-assessment taxpayers will likely recognise the tax liability when completing their returns, those in the PAYE system may not recognise the tax is due until a tax code change affects their take-home pay or pension income. 

How the tax system works

Income tax applies to earnings and pension income first, before savings income and dividends at your marginal rate. This means the government could come calling for 20p, 40p or even 45p from every pound of interest your bank pays out, depending on your other income.

Most people have a personal savings allowance – £500 or £1,000 for higher and basic rate taxpayers respectively – which offers some protection from the taxman’s clutches. Likewise, ISAs and pensions are the perfect way to shield your savings and investments and maximise your returns.

In retirement it is common to hold a little more cash. People often want to de-risk some of their investments and those with a good handle on their spending needs might look to build a cash flow ladder, or funnel, to match what they’ve got planned for the next few years. With an immediate need to take income from assets it is natural to focus a little more on capital preservation, meaning cash becomes an increasingly useful tool, despite the risks from inflation over the long term.

Unfortunately, that appears to be leading to many pensioners suffering a tax bill on their cash savings, with increasing numbers being dragged into higher tax bands too.

Tips for avoiding an unnecessary tax bill

1. Don’t take money out of your pension unless you need it

You’ll pay income tax on withdrawals above your tax-free cash allowance and, once it’s outside a pension, you may be subject to capital gains or dividend tax if you invest it elsewhere.

If you park the money in cash, you may find yourself with an added income tax bill – joining more than 1 million pensioners with a tax liability on cash savings. 

2. If you want to hold cash as part of your investment strategy, you can do so within a pension

You don’t have to hold the money in the bank. Your provider may offer a relatively attractive rate of interest on cash held in a pension, or you could hold investment products that are comparable to cash, such as money market funds.

You could also think about using an ISA to shelter up to £20,000 a year. Some savers have been paying into regular savings accounts chasing a fractionally higher return in recent years, but that may have backfired for those who find the tax bill now outweighs any additional interest earned and regret not paying into an ISA sooner. 

3. Split cash savings accounts efficiently between a married couple

You could give your spouse cash savings to use up their tax-free personal savings allowance. That’s especially helpful if you’re a higher or additional rate taxpayer and your partner is a basic rate taxpayer, meaning they benefit from the full £1,000 allowance.

If one of you has income below the personal allowance (£12,570 for 2025/26), you could also benefit from the starting rate for savings. This extra allowance is worth up to an additional £5,000 for those on lower incomes and could let you earn up to £18,570 in income and savings interest without paying any income tax.

The starting rate begins as a £5,000 tax-free band but once your non-savings income – for example, income from your pensions, including the state pension – hits £12,570, you’ll lose £1 of the starting rate for every £1 above this level.