Income tax does not just apply to earnings from your employment. Normally, interest from any savings that you have is taxed too, at 40 per cent for higher-rate taxpayers and 20 per cent for basic-rate taxpayers.

However, if you begrudge having to pay tax on your rainy day funds there are several ways to save tax-free.

Cash Isas

The most basic tax-free savings vehicle is the cash Isa, available from most banks and building societies. Anyone aged 16 or over can apply for an account. However, those under 18 can only invest money that is from sources other than their parents.

Income tax is not levied on the interest you receive from a cash Isa, unlike ordinary savings accounts.

How much can you save?

At present you can put up to £3,600 in a cash Isa each tax year. However, from October 6, 2009 anyone aged over 50 can invest £5,100. Everyone will be able to save this amount from April 6, 2010.

The tax year runs from April 6 to April 5 and it is important to use as much of your annual allowance as you can within that time as it cannot be carried over into the next financial year- cash Isas are sold on the basis that if you don't use it, you lose it.

Each year you can build on your existing cash Isa, or open a new account with a different bank and transfer your money. You can only have one cash Isa with one savings firm in a tax year. You cannot replace cash in your chosen Isa account once you have withdrawn it, even in the same tax year.

Not all cash accounts accept transfers, so this is something worth bearing in mind when comparing deals. As with standard savings accounts, there are a number of different types of cash Isa - easy access, fixed rate and notice accounts.

Stocks and shares Isas

You have to be 18 or over to invest in a stocks and shares Isa. Permitted investments include unit trusts, investment trusts, individual shares, corporate bonds and gilts.

Only one stocks and shares Isa is permitted per tax year but Isa wrapper products from online investment supermarkets allow you to put funds from several management firms into one Isa account.

Another advantage of Isas is that they do not have to be reported on self-assessment tax forms.

How much can you save?

You can currently invest up to £7,200 in a stocks and shares Isas each tax year. This will change to £10,200 for those over 50 from October 6 and be extended to younger people in the 2010-11 tax year.

It is ok to transfer money from your cash Isa into a stocks and shares Isa but not the other way round.

National Savings & Investments (NS&I)

NS&I offers tax-free products including cash Isas, savings certificates (fixed-interest and index-linked) and children’s bonus bonds.

Premium bonds are also tax-free. Anyone over the age of 16 can buy up to £30,000 of premium bonds. You are entered into a monthly prize draw with the chance of winning a jackpot of as much as £1million, with over a million other, smaller, tax -free prizes available.

Child Trust Funds

Parents of children born on or after September 2002 are entitled to a payment of £250 from the Government, or £500 if the family is on income support. A further payment of the same amount is made when the child reaches seven.

This money has to be invested in a Child Trust Fund, a tax-free account, and can be topped up each year by up to £1,200, by friends, family or parents. At the age of 18 the money is available for the child.

R85 form

If you are a non-taxpayer you should fill in form R85 to ensure that you receive 'gross' interest on your bank and building society savings - interest before tax is deducted. You will normally have to complete a new form every time you open a new account.

To reclaim any tax you think has already been unfairly levied on your savings request a R40 form from HMRC.

Links

Five news stories

Isa limit lifted to £10,200

Fraud alert on Premium Bonds

New law threatens 'silver saver' accounts

NS&I cuts premium bond prize

Faster Isa transfers are now on their way

Five features

Start taking advantage of higher Isa limit

Q&A: Child Trust Funds

Ten things you should know about Isas

National Savings & Investments explained

The beginners guide to Isas

Five websites

National Savings & Investments

HM Revenue & Customs

Compare cash Isas

Child Trust Fund

Money Made Clear