How to cut your losses on the interest on your savings
Published 20/10/2013 | 05:00
SAVERS were one of the biggest losers in last Tuesday's Budget. Finance Minister Michael Noonan's decision to hike savings tax yet again means that most people will lose almost half of the interest they make on their hard-earned savings from the start of 2014.
The DIRT (Deposit Interest Retention Tax) rate will rise to 41 per cent this January – more than twice the rate it stood at before the first austerity Budget of 2009. Furthermore, up until now, it was largely the self-employed who had to pay 4 per cent PRSI on their savings interest.
As PAYE workers will also have to pay 4 per cent PRSI on their savings interest from this January, most savers can expect to kiss goodbye to 45 per cent of their savings' interest in tax. So if you earn €200 in interest on your savings next year, you'll lose €90 of that to tax.
The hike in savings tax, along with the paltry deposit interest rates paid by many banks, has made the traditional deposit account less attractive to many people. Most banks are paying less than half the interest on savings accounts today than they did in 2008 before austerity kicked in.
Furthermore, inflation – which erodes the value of savings over time – is expected to pick up over the next few years.
So is there any way to dodge the higher rate of savings tax?
If you're a cautious investor who is reluctant to put your savings anywhere apart from a traditional deposit account, you could almost double your interest by putting your money into a DIRT-free savings account.
These accounts, which are largely offered by State Savings Ireland, allow you to earn interest on your savings without paying DIRT. The savings cert from State Savings, for example, pays 2.11 per cent interest a year tax free.
If you save €10,000 into a savings cert, you'll earn €1,100 in interest after five years – the equivalent of about €220 a year in interest. Put €10,000 into an ordinary bank account that pays a similar interest rate of 2.11 per cent, however, and you'll earn about €126 in interest a year after paying tax – once the higher 41 per cent DIRT rate kicks in this January. Add in the 4 per cent PRSI, and the amount of interest you get into your hands will be about €117.
So in this case, the investment return you get from lodging €10,000 into an ordinary bank deposit account is almost half of what you'll make if you put it into a DIRT-free State Savings account.
You can also earn interest tax-free on the State Savings' Childcare Plus and Instalment Savings accounts, as well as on savings bonds. Although you pay DIRT on the annual interest earned on National Solidarity Bonds, you get a tax-free lump sum bonus payment when your bond matures.
The main drawback of DIRT-free accounts is that you must usually tie up your money for a number of years, according to Vincent Digby, founder of the financial advisers Impartial.
If you're planning to escape the DIRT hike by pouring your savings into a State Savings account, do so quickly, advised Digby.
"I suspect the Irish banks will soon be lobbying the Government to get the interest rate paid on State Savings products reduced," said Digby. "Otherwise, the banks will say they're being undermined."
Your bank may offer a DIRT-free account. Bank of Ireland, for example, offers a three-year special term account where you can earn a certain amount of interest tax-free.
Another way to get around the DIRT hike is to open an interest-first deposit account, where your bank pays the interest you'll earn on an account upfront. This, however, is only a short-term solution.
"In the short-term, depositors should consider interest-first products, where interest is paid within 16 days of opening the account and where DIRT is charged at the 2013 rate of 33 per cent – for accounts opened in 2013," said Aoibheann Daly, deposit portfolio manager with Finance One.
Permanent TSB offers a number of interest-first deposit accounts, including a one-year interest-first account which pays 2.45 per cent interest on lump sums of €10,000 or more. KBC Bank offers an interest-first deposit account which pays 2.35 per cent interest on lump sums of between €3,000 and €1.5m.
If you're considering opening an interest-first deposit account to put off paying 45 per cent tax on your savings, don't leave it too late in the year to do so – it may take a few weeks to get your interest in the bag. It's worthwhile checking with your bank for the latest date that you can open an interest-first deposit account this year before you get hit for PRSI and the 41 per cent DIRT rate.
The massive hike in tax on savings interest as well as the dismal deposit interest rates will encourage many people to move into investment funds, according to John Geraghty, chief executive of LABrokers.ie.
"Some savers are prepared to take a greater risk by considering some forms of life assurance regular savings or single premium savings products," said Geraghty.
Although you could make a higher investment return on a well-chosen investment fund or life assurance policy than you would on a deposit account, the exit tax you pay on any profit you make when you cash in your investment was increased from 36 per cent to 41 per cent in last week's Budget.
However, you can reduce the impact of the 41 per cent exit tax by choosing an investment fund or life assurance policy where the returns are allowed to build up tax-free within the fund or policy for eight years.
With these funds, you have the benefit of reinvesting the annual return made on a fund or policy for eight years (known as gross roll-up) – rather than paying tax on those returns each year. You'll still have to pay exit tax on your return when you cash in your fund, but the higher return should ease the blow of that tax bill.
"Other advantages of investment funds are that you'll get a more diversified investment – and you have a professional managing your funds," said Digby.
If you have been a cautious investor in the past, be careful about jumping into risky investment funds.
"Choose a middle-ground investment such as an absolute return fund as these funds will usually be less volatile and have a lower risk than others," said Digby. Some of the funds he recommends include the Standard Life Global Absolute Return Strategies fund and Zurich's Active Asset Allocation fund.
Gary Hanrahan, managing director of financial advisers Capital Options, recommended Investec's Wealth Options Kick Out Bond for people who are prepared to take some risk with their savings.
Buying shares directly is now the most tax-efficient investment as long as you choose shares where you expect to make your money from capital growth rather than dividend income, according to Digby.
Capital growth measures the increase in the value of a share after you bought it. You usually pay 33 per cent capital gains tax on any profit you make when selling shares. Though this is high, it is a lot less than the amount of tax you pay on any dividend income earned on shares.
Dividend income is usually taxed at your marginal rate of income tax. You must also pay the universal social charge on dividend income. Furthermore, from the start of 2014, PAYE workers will get hit with PRSI (self-employed people are already paying PRSI on dividend income). So if you're a higher rate taxpayer and you're earning more than €100,000, you could lose 55 per cent of dividend income to tax.
The downside of investing in shares directly is that you're carrying a greater risk than you are when investing your money in a traditional deposit account. "Your tax affairs will also be more difficult to organise," said Digby.
Rory Gillen, founder of GillenMarkets, believes that equities offer the best value when it comes to investments.
"Coca Cola's growth rate may be slower now than in the distant past, but a 3.3 per cent starting yield plus even 4 to 5 per cent annual growth in that yield offers investors the prospect of an annual return of 7 to 8 per cent. This beats the pants off bank deposits and longer-dated government bonds. A German 10-year bond, for example, yields only 1.9 per cent and offers no growth," said Gillen.
If you invest too heavily in one particular share, you risk losing everything if that share performs badly. It's important therefore to choose your shares carefully. You need to be careful not to have all of your eggs in the one basket.
Before you take the leap from a deposit account into shares or an investment fund or life assurance policy, get independent financial advice.