Investors need to be wary about the impact of the new Dividend Allowance on their tax bills and income returns.
A Chancellor in search of savings often poses a risk to investors; George Osborne’s decision last summer to introduce new rules on dividend taxation in April is a case in point.
At first sight, the change could almost look like a handout. From April, the first £5,000 of dividend income earned each year will be tax-free, regardless of other income. Above that ceiling, however, dividend income will be liable to tax at a rate of 7.5% (up from 0%) for basic rate taxpayers, 32.5% for higher rate taxpayers (up from 25%) and 38.1% for additional rate taxpayers (up from 30.56%).
The new Dividend Allowance replaces the notional 10% tax credit on dividends, which will be abolished. The tax credit represented the tax that had already been paid on profits by the company declaring the dividend, and meant that a basic-rate taxpayer had no further tax liability.
In future, no tax will be deducted at source; taxpayers will need to use Self Assessment to pay any tax due.
Winners and losers
The Chancellor claimed that “85% of those who receive dividends will see no change or be better off”. However, the Treasury expects this measure to generate additional tax receipts of £6.8 billion by 2020/21.
So what will the change mean compared to the previous tax position on dividends?
“For a basic rate taxpayer with dividend income up to £5,000, the change will be tax-neutral, but they will be worse off for dividends in excess of that amount,” advises Tony Müdd, Divisional Director, Tax and Technical Support at St. James’s Place. “If higher and additional rate taxpayers restrict their dividend income to £5,000 then they will be better off. Above that level, the changes will provide an initial benefit; however, the higher the dividend income, the worse off they will become.”
The tipping point for a higher rate taxpayer will come when their dividend income reaches £21,667. For additional rate taxpayers, that point will be at £25,265. Above these levels, those in the top two tax brackets will pay more Income Tax as a result of the change.
*Assuming no other non-dividend income
Dividend income can also be covered by the personal allowance – the amount of income you can earn before being taxed – which means that someone receiving all of their income in dividends could be paid up to £16,000 and not be liable for any tax.
Yet the new measure does not mean that the first £5,000 of dividend income is discounted from tax calculations, as some had assumed when the new rules were announced. All dividend income will still count towards total income, when HMRC calculates an individual’s Income Tax band.
Avoiding the drop
Crucially, the change does not affect pension funds, which are currently exempt from tax, nor will it affect dividends paid out from shares held in ISAs.
“Those looking to beat the dividend tax rises should therefore consider making full use of tax shelters such as an ISA,” suggests Müdd. “Even if investors think their income or gains will currently fall within tax-free allowances, the fact that unlimited dividends can be withdrawn from an ISA, without any further tax liability, overcomes the risk of rules changing in the future.”
Individuals might consider increasing pension contributions to reduce their taxable income. Such a move would create some extra slack in the basic rate or higher rate tax band, slack which could then be used to increase (or just to avoid reducing) your dividend stream without getting bumped up into the next tax bracket.
For income-generating investments held outside of these tax-advantaged wrappers, it makes sense for married couples and civil partners to spread assets between them, as this enables them to make maximum possible use of each individual’s allowance. Couples should also ensure that taxable dividends are paid in the name of the spouse who pays the lowest tax rates.
Clearly, for private investors seeking income, the new Dividend Allowance will have important implications. For small business owners, it could be a game changer. Under the current tax system, many small business owners choose to pay themselves through dividends. That culture may now begin to change.
For example, a small business might have a policy of paying a director a salary of just £8,000. That is enough to ensure he or she is entitled to state benefits but it remains sufficiently small to avoid triggering Income Tax or National Insurance liabilities. The director then elects to receive dividend payments. Had the director received £30,000 of dividend payments in 2015/16 under this arrangement, he would not have paid any tax on them. From April, however, the new tax rules would reduce his dividend income to £28,350.
Accountants have reported that more of their clients have been taking cash out of their businesses to avoid higher rates of tax from April. Even though such forestalling is intended to reduce tax, the government won’t have minded the exchequer receiving money at an earlier stage.
To help address the challenge, small business owners might want to use some of the methods already mentioned to reduce employees’ taxable income, such as increasing pension contributions, or paying dividends to a spouse or civil partner to make use of their Dividend Allowance.
However, even after the reforms, for many small business owners, remuneration through dividends will continue to incur less tax than through salary.
The levels and bases of taxation and reliefs from taxation can change at any time and are generally dependent on individual circumstances.