Changes to dividends tax for investmentsJuly 23rd, 2015 by Dan Woodruff
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- Increase in tax on dividends affects investments and business owners
- £5,000 tax-free dividend allowance (reducing to £2,000 from April 2018)
- Remaining dividends taxed at 7.5% above current rates
- Winners and losers under the new rules
- The real target of the changes are small business owners
- Your non-dividend income is important
What are dividends?
Dividends are the income you receive on most shares you own. The company typically pays an income each year based on the profits they make. This is taxed as income, but in a different way to earned income.
Previous taxes on dividends
Previously dividends were treated as if they had received a ‘tax credit’ of 10%. This was a legacy of previous tax rules, but meant that 0% income tax payers and 20% income tax payers had no further liability to tax on their dividends. 40% income tax payers were liable to an additional 25% tax, and 45% tax payers an additional 30.6% tax. Dividends held within an ISA are not taxable, although the 10% tax credit outlined above was not repaid.
New tax on dividends
The new rules on dividends tax came in from April 2016. The tax credit was scrapped. Instead you get a tax-free dividend allowance of £5,000 per person, which will reduce to £2,000 from April 2018. Dividends above this figure will be taxed at the following rates, according to your income tax position:
- 20% income tax band – 7.5%
- 40% income tax band – 32.5%
- 45% income tax band – 38.1%
This means that after the £5,000 allowance your dividends are effectively taxed at 7.5% extra compared to current rates. Dividends less than the £5,000 allowance will be tax-free. The reduction in the £5,000 annual dividend allowance from April 2018 could mean additional tax of £225 per person.
The tax-free dividend allowance
This £5,000 allowance should mean that most investors will not pay additional tax, or could even pay less tax on dividends. If we imagine that most shares pay a dividends between 1-5%, the amount of shares you could hold and avoid dividend tax completely could be quite large:
- 1% dividend yield = £500,000 worth of shares
- 2% dividend yield = £250,000 worth of shares
- 3% dividend yield = £166,666 worth of shares
- 4% dividend yield = £125,000 worth of shares
- 5% dividend yield = £100,000 worth of shares
Don’t forget that in a properly diversified investment portfolio you may hold other types of assets which are not affected by the changes to dividend tax. If your portfolio holds fixed interest funds such as corporate bonds or gilts, cash, or property, then these investments are likely to be taxed as interest, not dividends. The rules on these investments (which are not as attractive as the dividend tax) are unchanged.
If you hold an investment portfolio worth £250,000, which is split £100,000 in fixed interest, and £150,000 as shares, the additional dividend tax would only apply to dividends on the shares. The shares could attract dividends of 3.33% before you start paying any tax on your dividends.
Investment dividends – winners and losers under the new dividend tax rules
This depends on your tax position, and the amount of dividends you receive. Any dividends you get in ISAs or pensions will be tax-free. Where you should be concerned is if you receive more than £5,000 in dividends into a taxable investment account or as directly owned shares. Of course, in a married couple you can each receive £5,000 in dividends before you pay any tax. Generally, higher rate tax payers will be better off. Basic rate tax payers with dividends over £5,000 will be worse off.
The new dividend allowance is not taken in addition to the standard income tax allowances. Therefore, you need to take particular care of the non-dividend income you have (such as earnings and pensions). If your normal earnings are close to the higher rate 40% income tax band your dividend allowance may mean that dividends are taxed as a Higher rate rate payer. See the HMRC website for some further examples.
Example 1 – loser
Jane earns £10,000 per year and is a basic rate (20%) income tax payer She also gets £10,000 per year in dividends. Under current rules her dividends will be tax-free. After April 2016 her first £5,000 of dividends will be tax-free, but the remaining £5,000 will be taxed at 7.5%. Jane will be £375 worse off.
Example 2 – winner
John earns £45,000 per year and is a higher rate (40%) income tax payer He also gets £5,000 per year in dividends. Under current rules all his dividends are taxed at 25%, which would cost him £1,250 per year in additional tax. After April 2016 his first £5,000 of dividends will be tax-free. John will be £1,250 better off.
Example 3 – winner
Jim earns £45,000 per year and is a higher rate (40%) income tax payer He also gets £10,000 per year in dividends. Under current rules his dividends are taxed at 25%, which would cost him £2,500 per year in additional tax. After April 2016 his first £5,000 of dividends will be tax-free, and the remaining £5,000 of dividends would be taxed at 32.5%. John will be £875 better off.
Small business owner dividends – the real target of the new dividend tax rules
Many small business owners currently pay themselves using a combination of a relatively low salary and the remainder via dividends. The low salary is usually kept just above the National Insurance threshold, so that the business owner qualifies for the State pension. The remaining income is taxed as dividends and is therefore taxed at a lower rate than PAYE earnings. The business and individual also avoid paying National Insurance on dividend payments. The justification for this is that the business owner’s profits are already taxed at 20% under corporation tax, before they can be withdrawn from the business. In addition, this lower taxation has always been seen as an incentive for business owners to take the risks necessary to set up a business; their reward has been slightly lower tax.
A business owner example
Robert owns a limited company and made a profit of £50,000 this year. His business is taxed under corporation tax at 20%. He therefore pays £10,000 in corporation tax. He is left with £40,000, which he pays to himself, £8,000 as a salary, and £32,000 as a dividend. The dividend payment would now be subject to 7.5% tax after the deduction of the £5,000 tax-free allowance. Therefore £27,000 would now be taxed at 7.5%, which means Robert will pay an additional £2,025 in tax! NB. The above figures have been slightly simplified to ignore income tax personal allowances and National Insurance, just to more easily make the point about the increase tax on dividends!
Ways to avoid extra tax on dividends
Use your tax-free dividend allowance
It goes without saying that you should fully use your tax-free dividend allowance of £5,000. If you have dividends of more than £5,000 you could transfer assets to your spouse (tax-free) and double up your tax-free allowance to £10,000.
Use ISA allowances
Each person has a tax-free ISA allowance of £15,240 for the 2016/17 tax year (£20,000 from April 2017). You should use your ISA allowance in April each year to maximise your tax-free savings. Dividends paid within an ISA will be tax free no matter what amount.
Lower earning spouse take dividends
If your dividends are greater than £5,000 and one spouse pays income tax at a lower rate than the other, consider transferring dividend paying assets to the lower earning spouse. That way you could reduce your dividend tax by 25%.
Consider income levels
Some assets pay greater income yield than others. You could transfer higher yielding investments to your ISAs or to the lower taxed spouse, and reserve the lower yielding assets for the higher earning spouse.
Review your investments
These changes to dividends could have a major impact on your investment strategy. We recommend an investment review so that you understand the tax implications of the changes. Action now could help to save you a lot of money.