As more Brits pay tax on savings accounts here’s how you could get 5.58% tax …

Victoria Scholar, head of investment at Interactive Investor, issues inflation and interest rate warning

Last month, an astonishing five of the 10 most popular investments were gilts, according to investment fund platform AJ Bell. The site’s head of investment analysis Laith Khalaf said investors are piling into the sector as they anticipate the peak of the interest rate cycle. “DIY investors have been on a gilt buying spree. After bond prices fall and yields rise, many suddenly feel they’ve never had it so good.”

Government-backed gilts pay as much as best buy savings accounts but with greater security, instant access and a potentially lower tax bill, depending on your circumstances.

Gilt-edged securities, to use their full name, plunged out of favour when central bankers slashed interest rates almost to zero after the financial crisis, but now two-year gilts yield around 4.5 percent. 

Yields may not go much higher from here, with the Bank of England hinting we are nearing peak interest rates.

Bond prices are cheap today but should pick up when interest rates slide, offering the prospect of capital growth to private investors.

This is where much of the excitement lies because there is no capital gains tax to pay on gilts. Khalaf said they work particularly well for higher-rate taxpayers who now find themselves paying income tax on their cash deposits, having breached their personal savings allowance (PSA).

The PSA allows basic rate taxpayers to take £1,000 of savings interest each year free of tax, falling to £500 for higher rate taxpayers and zero for those on the additional rate.

As savings rates rise more people are using up their PSA and handing savings interest to HMRC, Khalaf said. “For those in this situation, gilts may be more tax efficient.”

Gilts may also appeal to those who have used up their annual £20,000 Isa allowance, as their tax benefits do not rely on the tax-free wrapper.

Investors don’t just buy newly issued gilts, they also trade older gilts on the secondary market, which often have near-zero yields.

That will not tempt anybody today so bond sellers have to slash prices to whip up demand, and this is where capital gains come into it, Khalaf said.

He takes the example of a government bond with a coupon of 0.5 percent and a face value of £100, to be paid to the bond holder on maturity in one year’s time.

Typically, each bond bought will cost an investor £95 today (and most people buy hundreds or thousands). “The 0.5 percent yield would be taxed as interest, giving a higher rate taxpayer a return of 0.32 percent after tax. However, they would also get a tax-free capital gain of 5.26 percent, as they paid £95 and get £100 back. Their total net return after tax is therefore 5.58 percent.”

While is still possible to get a one-year fixed rate savings bond paying up to 6.1 percent, that may be subject to tax.

For a higher rate 40 percent taxpayer who has used up their PSA, the net return after tax is just 3.7 percent.

Better off private investors have spotted the opportunity, with HM Treasury Gilt 0.125% is now AJ Bell’s best selling investment of all, followed by HM Treasury Gilt 0.25%.

Gilts are also backed by the government, so you are guaranteed to get your money back at maturity, Khalaf said. “This may appeal to cash savers with more than the £85,000 covered by the Financial Services Compensation Scheme.”

Unlike fixed-rate cash accounts you can get your money back at any time by selling gilts, although this will be at a market price which could mean selling at a loss.

There is no stamp duty on gilts, unlike shares, but you may have to pay stockbroking charges,

Khalaf said. “The biggest problem is that gilts can also be difficult to get your head around, so may suit more experienced investors.”

You can keep things simply with a low cost exchange traded fund (ETF) investing in government bonds, such as the iShares Core UK Gilts ETF or the Vanguard UK Gilt ETF, which can be bought inside a tax-free Isa.

Another option is something called a money market fund, which are considered very low risk, as they invest in cash and short-term bonds, and aim to never lose money.

Money market fund yields were low for years, but today Royal London Short Term Money Market pays 5.24 percent, according to Trustnet, with a low net ongoing charge of just 0.1 percent.

Lyxor Index Fund Smart Overnight Return ETF and Vanguard Sterling Short Term Money Market are also popular.

Khalaf said the interest from these funds is taxable, unless held in an Isa or self-invested personal pension. “Yet they now offer a reasonable return without much risk and with ready access to your money.”

For income seekers willing to take on more risk in a bid to get a higher rate of interest, Khalaf highlights two FTSE 100 stocks that are also bestsellers today, Legal & General Group and Phoenix Group Holdings. “These stocks are carrying prospective yields of 8.9 percent and 10 percent.”

Victoria Scholar, head of investment at Interactive Investor added: “Buying individual shares can be highly rewarding but also carries greater risk.”

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