When savers deposit money in a fixed-term account or an account that requires notice of withdrawals, they may well assume that, if they incur a penalty for early withdrawal, they will only have to pay tax on the net amount of interest received. However, such penalties are normally classified as bank charges and cannot be deducted against interest for Income Tax purposes, as a couple recently found out to their cost.
The couple had moved from London to Nottingham to be nearer to their adult children. After selling their flat in London, they deposited the proceeds in two ISAs and two fixed-term savings accounts. They rented for a year while they looked for a house to buy. After finding a suitable house sooner than they had anticipated, they withdrew money early from their fixed-term savings accounts to fund the purchase, incurring early withdrawal penalties.
The husband was charged £2,691, the equivalent of 90 days' interest. However, he subsequently received a calculation from HM Revenue and Customs (HMRC) showing a tax liability on the gross interest of £2,877 he had earned in the relevant tax year, with no deduction for the early withdrawal penalty. After his Personal Savings Allowance of £1,000, he had to pay tax of £575, despite only having received net interest of £186. His wife, a higher-rate taxpayer, was liable for tax on £1,002 of interest after deducting her Personal Savings Allowance of £500.
They contacted HMRC, which confirmed that Income Tax was payable on the full amount of interest earned on their savings and could not be offset by bank charges.