Savers and investors with large shareholdings outside of individual savings accounts and pensions could lose out under plans to simplify the taxation of dividends next year. But there are ways to make sure your portfolio is more tax-efficient.
Taxation of dividends is to change from April 2016, as announced by George Osborne in last week's Budget. Starting in the next tax year, investors will have a tax-free dividend income allowance of £5,000, above which dividends will be taxed at 7.5 per cent for basic-rate taxpayers, 32.5 per cent for higher-rate taxpayers and 38.1 per cent for additional-rate taxpayers. If your dividend income takes you from one income tax band into the next, you will pay the higher dividend rate on that portion of income.
Under the current regime, dividends carry a 10 per cent tax credit. This means that basic-rate taxpayers have no further liability, while higher-rate and additional-rate taxpayers have their liability reduced to 25 per cent and 30.56 per cent, respectively, of the amount received.
Alex Henderson, tax partner at PwC, says: "The changes to the taxation of dividends remove the final vestiges of the system introduced in the early 1970s where a credit was given for tax paid by the company. Overall, the chancellor is expecting to raise £3.5bn from the change over the next five years."
"Scrapping the dividend tax credit is great news for investors and the introduction of a £5,000 dividend allowance for all taxpayers means the majority of investors will not pay tax on any dividends received," says Adrian Lowcock, head of investing at AXA Self Investor. "The power of reinvested dividends should not be underestimated for long-term investors and - in a world of low interest rates on cash - income earned from investments has become of huge importance to many investors."
Dividend tax rates (%)
| 2015-16 | 2016-17 | |
|---|---|---|
| Non taxpayers | 0 | 0 |
| Basic-rate taxpayer | 0 | 7.5 |
| Higher-rate taxpayers | 25 | 32.5 |
| Additional-rate taxpayers | 30.6 | 38.1 |
The government says that ordinary investors with modest dividend income from company shares will see no change in their tax liability, and some will pay less tax. With the increases in the personal allowance and the introduction of a personal savings allowance, from April 2016 individuals will be able to receive up to £17,000 of income per year tax-free, and on top of this invest up to £15,240 a year tax-free in an individual savings account (Isa).
The personal allowance is £10,600 and rises to £11,000 in April 2016 and £11,200 from 2017-18.
From April 2016 a personal savings allowance will give basic-rate taxpayers a £1,000 allowance against savings income, and higher-rate taxpayers a £500 allowance - an effective tax saving of £200 to both. This will cover cash savings, peer-to-peer lending and bonds. But there is no allowance for additional-rate taxpayers.
Following the changes in dividend taxation non-taxpayers will not see any change, and neither will basic-rate taxpayers with dividend income under £5,000. But basic-rate taxpayers' rate will jump from 0 per cent to 7.5 per cent on dividend income over £5,000 that is not held in a tax wrapper such as an Isa.
Some higher-rate taxpayers will be better off under the new regime. "There will be a dividend income break-even point where the tax payable on dividends under the current system equals the tax on the new system," says Danny Cox, chartered financial planner at Hargreaves Lansdown. "For higher-rate taxpayers this level of dividend income is £21,667."
Under the current system, for higher-rate taxpayers £21,667 of net dividends taxed at 25 per cent = £5,416.75
From April 2016 £5,000 of dividends taxed at 0 per cent = £0
£16,667 of dividends taxed at 32.5 per cent = £5,416.75
So, from April 2016, higher-rate taxpayers will be better off as long as their dividend income does not exceed £21,667, but worse off if their dividends exceed this.
Additional-rate taxpayers will be better off under the new regime providing their dividend income does not exceed £25,401, but worse off if their dividends exceed this level.
Those with income over £100,000 start to lose their personal allowance at an effective tax rate of 60 per cent on earnings or interest income. Experts say dividends falling within this band could be subject to an effective tax rate of 52.5 per cent.
Tax treatment of £1,000 dividend from April 2016 in excess of £5,000 allowance
| Gross dividend (£) | Tax due (£) | Dividends after all tax (£) | |
|---|---|---|---|
| Non-taxpayer | 1,000 | 0 | 1,000 |
| Basic-rate taxpayer | 1,000 | 75 | 925 |
| Higher-rate taxpayer | 1,000 | 325 | 675 |
| Additional-rate taxpayer | 1,000 | 381 | 619 |
Source: Hargreaves Lansdown
The government says those who receive significant dividend income, for example due to very large shareholdings of more than about £140,000 or from a closed company, will pay more tax. This figure is based on the current FTSE All-Share yield of around 3.5 per cent.
"Under the current regime, an individual who has no other income can receive approximately £38,000 of dividend income tax-free," says Nimesh Shah, partner at Blick Rothenberg. "From April 2016, the same individual will have a tax liability of £1,700."
"People should fully use tax shelters such as an Isa, even if they think their income or gains will currently fall within tax-free allowances," advises Mr Cox. "You never know when things might change in the future so it's best to bank your tax breaks while you still can."
SEVEN WAYS TO REDUCE TAX ON DIVIDENDS
Married couples
Spread your taxable share portfolios between two people to make full use of each spouse's £5,000 allowance. Also make full use of your personal allowances and basic-rate tax bands where applicable, so that taxable dividends are paid in the name of the spouse who pays the lowest tax rates.
Use tax wrappers...
Sheltering taxable investments in an Isa will become more important as unlimited dividends can be withdrawn from an Isa tax-free. There is also no capital gains tax to pay in this wrapper. You can shelter £15,240-worth of existing investments in an Isa this tax year.
For retirement savings where money is not needed until age 55, self-invested personal pensions (Sipps) offer tax-free dividends, while most people can invest up to 100 per cent of earnings effectively capped at £40,000 in this tax year and receive tax relief of up to 45 per cent.
...but be clever with tax wrappers
A diverse portfolio will have shares and funds that generate different levels of dividend income yield. Shelter those that generate the higher yields in an Isa to maximise the dividend income tax allowance. For example, a taxable portfolio of £125,000 with a yield of 4 per cent will generate £5,000 a year and use up the dividend allowance. However, a portfolio of £500,000 yielding 1 per cent generates the same £5,000 a year.
In most cases, the income from fixed-interest funds and corporate bonds is subject to interest tax, not dividend tax. From April 2016, the first £1,000 of interest income from these holdings will be free of income tax under the new personal savings allowance, or £500 for higher-rate taxpayers. This provides the opportunity for tax-free income in addition to the dividend allowance and Isa income - so use this to offset the income from bonds and cash. The personal savings allowance also applies to taxable cash interest so ensure you don't exceed £1,000 a year or £500 if you are a higher-rate taxpayer.
Reduce taxable income
After the new dividend allowance, dividend tax is linked to the rate of income tax you pay. So reducing your other taxable income could also reduce the amount of dividend tax you pay. You might be able to reduce taxable income for a particular year by transferring income-bearing assets such as cash deposits to a lower earning spouse, or deferring withdrawals from a drawdown pension until a new tax year.
Offset with pensions tax relief
A pension contribution can be used to reduce dividend tax liabilities by taking advantage of the tax relief on the contribution. Effectively the basic-rate tax band is increased by the amount of the pension contribution, meaning larger gains might be realised before the higher rate of dividend tax is payable. For example, a pension contribution of £3,600 will extend the basic-rate tax band from £43,000 to £46,600 for the 2016-17 tax year. Then, providing other taxable income and taxable dividend income total less than £46,600 in this tax year, the dividend tax will be paid at 7.5 per cent rather than 32.5 per cent.
VCTs
Taxpaying, sophisticated investors happy to take higher risks could consider venture capital trusts (VCTs), which generate tax-free dividends - in addition to tax-free dividends from an Isa and the forthcoming £5,000 dividend allowance.
Offshore bonds
Dividend income within an offshore investment bond grows almost free of taxation, although there may be a small amount of withholding tax. Investors only pay tax when profits are withdrawn, although withdrawals of up to 5 per cent of the original capital a year can be taken without immediate tax charge. Dividend income can therefore be deferred and timed to when lower rates of tax might be paid. For example, a higher-rate taxpayer will pay 32.5 per cent dividend tax after the dividend allowance, whereas if deferred until the investor is a basic-rate taxpayer, withdrawals from an offshore investment bond would be taxed at 20 per cent.
• Broker Hargreaves Lansdown has set up a dividend tax calculator to help people work out what they will have to pay after 2016. It is available at http://www.hl.co.uk/shares/dividends-tax-calculator
