How to make your investment income more tax-efficient

It has been a rollercoaster of tax announcements for income investors over the past year. Initially, dividend tax rates were going to be cut from April 2023 onwards. Later, the measure was scrapped. Now, the divided tax allowance is being cut instead, a de facto hiking of the tax.

In his Autumn Statement on 17 November, chancellor Jeremy Hunt unveiled a series of tax increases, for a total bill of £25bn. The dividend tax allowance, which has been set at £2,000 since 2018 and was previously £5,000, will be reduced to £1,000 from April 2023 and cut again to £500 from April 2024. Dividend tax rates will remain at 8.75 per cent, 33.75 per cent and 39.35 per cent for basic, higher and additional rate taxpayers, respectively.

While you currently need £50,000 worth of investments yielding 4 per cent to hit the allowance, this will reduce to £25,000 from next year and to £12,500 from April 2024. If you receive £2,000 or more a year in dividends, in the 2024-25 tax year you will pay £131.25, £506.25 or £590.25 more in dividend tax than you do now – again depending on whether you are a basic, higher or additional rate taxpayer.

With the end of the calendar year approaching, now is a good time to double check that you are managing your income investments in the most tax-efficient way, so that you have plenty of time to make changes ahead of the next tax year if necessary.

What to prioritise in your Isa

We covered some of the strategies investors can use to mitigate their tax bill in last week's article on the slashing of the capital gains tax (CGT) allowance ('How to mitigate capital gains tax on funds and shares', IC 25 Nov 2022). Making the most of your individual savings account (Isa) allowance, including moving assets into the wrapper if you can, as well transferring investments to your spouse to make use of all the allowances available to the family, will help you pay both less dividend tax and less CGT.

Additionally, investors who have exhausted their allowances might want to reflect on how they split their income and growth investments, and which to prioritise holding in an Isa. 

But Simon Martin, chartered financial planner and tax consultant at St James's Place, stresses that taxes are just one factor and should not drive investment decisions. Don't let the tax tail wag the investment dog, as the saying goes. He also notes that all decisions depend on personal circumstances – somebody with a lower level of income, paying the basic rate of income tax, might find an income investment strategy more advantageous. 

But for higher and additional rate taxpayers, the CGT rate (20 per cent on assets other than residential property) is lower than dividend tax rates.

This “implies income yielding investments make more sense within a tax-efficient wrapper such as an Isa,” says Shaun Moore, tax and financial planning expert at Quilter. “Of course, the reality is that you’ll want a mix of assets, as you would still want to utilise the dividend allowance that is still available as well as the personal savings allowance.”

Even after April 2024, once the cuts to both allowances have fully come into effect, the £3,000 CGT allowance will remain significantly higher than the £500 dividend allowance. Additionally, while you can decide when to sell an investment and crystallise a gain, dividend distributions are out of your hands. Prioritising income investments within an Isa will give you a higher degree of control over your tax bill. 

One of the core features of income investing is the ability to reinvest your dividends to make the most of compounding. “In the case of the UK equity market, the vast majority of the real return over the long term – once inflation is factored in – has come from dividends,” says Jason Hollands​​, managing director at Bestinvest.

He calculates that over the last 20 years, the FTSE All-Share Index has returned 31.6 per cent in share price terms alone, but 236.3 per cent on a total return basis, reinvesting dividends (both figures are inflation-adjusted).

So if you do not need the income, reinvesting dividends is a great strategy. However, note that it doesn't really matter from a tax perspective – if the investments are held outside an Isa and you exhaust the allowance, you are liable for dividend tax whether you reinvest your dividends or not. This is something you might want to keep in mind when comparing the total return performances of growth and income investments.

Business owners

“The real target of the chancellor’s assault on the dividend allowance was undoubtedly small business owners rather than investors in stocks and shares,” says Hollands. Small business owners often only pay themselves a modest salary and use dividends for the rest. Dividend tax rates are lower than income tax rates; plus, dividends are exempt from national insurance contributions and can follow the often irregular cash flows of a small business. For many small business owners, paying themselves through dividends will still be the most tax-efficient solution, despite the dividend allowance cut.

From April 2023, businesses will also be hit by a higher rate of corporation tax, which will increase to 25 per cent from the current 19 per cent for companies with more than £250,000 in profits. Companies with less than £50,000 in profits will continue to pay the 19 per cent rate, while businesses earning between £50,000 and £250,000 will also pay the 25 per cent rate, reduced by a marginal relief that gradually pares back as profits approach the £250,000 threshold.

Company pension contributions are a key option to help mitigate tax bills. They receive corporation tax relief, do not incur national insurance for either the business or the owner and reduce exposure to income tax. You cannot access pensions until age 55 or, from 2028, age 57, but building a retirement fund is essential for your future financial wellbeing.

However, David Goodfellow, head of wealth planning at CGWM, notes that older business owners might be close to reaching the lifetime allowance, something to be aware of before making further pension contributions. The allowance is currently set at £1,073,100 and this threshold is frozen until April 2026.

If that is your situation, you are not left with many tax relief options, except for when you start exiting the business. If you sell all or parts of your company, you might qualify for business asset disposal relief (known as entrepreneurs’ relief prior to 6 April 2020) and would then only have to pay a 10 per cent rate on the gains (as opposed to the standard CGT rate). If you are selling shares or securities in the business, in order to qualify for the relief you must make sure that you have not incorporated so much cash into the business that it inadvertently becomes an investment company rather than a trading company, Goodfellow warns.

Finally, if your spouse is legitimately working within the business, it can be tax efficient to get them involved by paying them a salary or dividends, so that you can make use of all the allowances for which a family qualifies.