Higher returns on liquid savings are the bright spot in the sharpest interest rate hike cycle in modern history. If you shop around, you could earn more than 5% a year for the first time since the late 2000s. But rising savings rates obviously mean bigger tax bills. The Financial Times reported last week that taxes on savings interest earned by the government are expected to rise from £3.4 billion in 2022 to £6.6 billion this year, according to figures from the HMRC. Additionally, a million more people are expected to pay tax on their savings returns this year – a real administrative headache for both affected savers and tax authorities UK. However, from Personal Savings Allowances to Individual Savings Accounts (ISAs), there are ways to pocket all the interest you earn. And if your savings are currently huge, it's helpful to consider whether your money is being put to its best use.

Why are more savers paying tax?

The two factors at play here are higher interest rates and flat tax exemptions. After years of gloom, interest rates rose by 0.1% to 5.25 between December 2021 and August 2023. Savings rates offered by banks and building societies also followed, albeit sometimes slowly, exceeding 6% until recently. Additionally, the Personal Savings Allowance, which allows you to earn a certain amount of interest before tax, has not increased since it was introduced in 2016. This is part of the tax levy scheme larger than the government, known in the industry jargon as a tax drag, where frozen tax benefits would attract more people into higher tax brackets. What’s the savings allowance and how does it work? If you're a 20% tax payer, the first £1,000 of profit you make each year will be tax-free, while if you pay 40% tax the allowance will be halved to £500. Anyone in the 45% tax bracket gets no benefit: you pay land tax.As noted above, until recently, interest rates remained at historic lows, as reflected in low savings rates. The chart below shows the trajectory of interest rates over the past decade. Now that interest rates have risen sharply, more and more people are exceeding their savings limits, making their income taxable. At the time of writing, the best easy-access savings accounts earn 5.22%, while if you're willing to lock your money away for a year, you can get 5.91%. This means that if you are a 20% tax payer, the allowance can be used when accessible savings reach £19,150 – or £9,575 if you pay 40% tax. By contrast, in December 2021, before interest rates began to rise, the most accessible account paid just 0.71%. At this rate, a 20% taxpayer could save £140,000 without exceeding the personal savings allowance, reducing the need to use tax wrappers.

How can I pay less tax on my cash savings?

Luckily, there are ways to protect your savings from tax authorities. You should consider using your ISA allowance. You can invest up to £20,000 per year or £40,000 as a couple in a cash ISA and pay no tax on the interest you receive. I realize that some of you may prefer to use a Stocks and Shares ISA each year due to the higher potential returns, leaving you with little or no room for your savings. However, there are other things to think about. If you're married or in a civil partnership and you've both exhausted your ISA and personal savings allowance, then you should transfer most of your savings to whoever pays the tax rate highest and lower income. For example, you're in the 40% tax bracket while your spouse pays 20% and each has £25,000 in savings at 5% interest. You will pay £500 in tax (£1,250 x 40%), while your partner's tax bill will be £250 (£1,250 x 20%), for a total of £750. But keeping all the money in your partner's name reduces the tax liability to £500 (£2,500 x 20%), a saving of £250. Premium bonds are another option. Instead of earning interest, you enter a monthly withdrawal amount. Prizes range from £25 to £1 million and do not include tax, but there is no guarantee you will win. On the positive side, the bonus fund rate recently increased to 4. 65%, the highest level since 1999.

How much cash should I hold?

If your cash holdings are large enough to drain your savings, it could be a sign that you're holding too much. While cash is safer, the stock market, while exposing you to more risk, offers greater potential for growing your wealth over the long term. Savings rates have improved significantly over the past two years, but even the highest rates lag behind inflation – currently 6.7%. However, with price growth expected to slow down significantly later this year, this situation may soon change. How much money you choose to allocate to cash instead of investing in the stock market is a personal decision. This often depends on your short-term financial plans, your ability to withstand investment losses, and whether you are retired or still working. A useful rule of thumb is to keep at least six months' expenses in any easy-to-access savings account, such as a cash ISA, to cover emergencies, plus an extra to fund any immediate goals such as vacations and large purchases. If you're retired and taking an income reduction approach, you should keep your income in cash for two to three years - in or out of your SIPP - to avoid buying shares when prices are low. This will protect you against threats such as sequence risk, which can arise when you continue to sell shares when the market declines, potentially depleting your retirement funds faster than expected. Self-employed individuals may also want to keep a larger cash reserve as a backup if work dries up for any reason – or if an illness or injury forces you out of work.

How else can I reduce my income tax bill?

• Use pensions, including salary sacrifice

Contributing to a pension is a great way to immediately reduce your income tax bill, as long as you're willing to lose access to the money until age 55 (and until age 57 from 2028). You can contribute the lower of £40,000 or 100% of your income each year (known as the annual allowance) and get tax relief at your marginal rate - in other words, the higher lowest tax rate rate you pay, which can save you up to 45%. But if you're retired or earn more than £260,000 a year, your allowance could be just £10,000. If you're working, another option is to sacrifice your salary. This is where you exchange part of your salary for pension contributions. For example, you earn £60,000 a year and you agree to exchange £3,000 of your salary for your pension. As your income drops to £57,000, you will save £1,200 (£3,000 x 40%) in income tax plus £60 (£3,000 x 2%) on National Insurance (NI). Additionally, not only will the £3,000 pension payout escape income tax and NI, but the amount will be exempt from capital gains tax (CGT), while all the dividends you receive will also be covered by the tax authorities.

• Claim the marriage allowance if you can

Several tax benefits are available to married people, including marriage allowance. This allows you to transfer £1,260 of your personal income tax allowance to your spouse or civil partner, which could reduce their tax bill by up to £252. The only problem is that the highest earner can't pocket more than £50,270 a year. For example, say you earn £45,000 a year while your spouse earns £10,000. Because your spouse's income is below the personal income tax threshold of £12,570, they can transfer £1,260 to you, increasing your personal allowance to £13,830. While this doesn't yield huge savings, it can yield valuable extra cash without much effort.