Beat the dividend allowance cut

Impact of the dividend tax allowance cut

Source: AJ Bell

The dividend allowance was introduced in April 2016 and replaced a complicated system of tax credits. Before this date, a notional 10 per cent tax credit on dividends applied to basic-rate taxpayers, while higher-rate and additional-rate taxpayers had their liability reduced to 25 per cent and 30.56 per cent, respectively, of the dividend amount received.

"When the dividend allowance was introduced, it was seen as a welcome simplification of the horrendously complex dividend tax credit system," says Sarah Coles, personal finance analyst at Hargreaves Lansdown. "The less palatable fact that dividend taxes were rising was sweetened with a thick topping of tax-free allowance that meant only those with around £140,000 or more in investments [yielding about 3.5 per cent] were likely to pay it. The cut in the dividend allowance from £5,000 to £2,000 in April scrapes away the vast majority of the sweetener, so that anyone with around £55,000 in investments may face the tax, which will leave many investors with a bitter taste in their mouth."

So while a basic-rate taxpayer who currently receives £5,000 in dividends pays no tax, from 6 April they will incur tax of £225. "And this will be £975 for a higher-rate taxpayer and a whopping £1,143 for an additional-rate taxpayer," adds Tom Selby, senior analyst at AJ Bell Youinvest. "This change will make it even more important for people to ensure their dividend-paying investments are held in tax wrappers such as Isas or self invested personal pensions (Sipps), where they can continue to enjoy tax-free dividend income."

Although tax considerations shouldn't change your investment focus, there are a number of ways to mitigate the dividend allowance cut.

Use your annual Isa allowance

Isas are likely to form a core part of your strategy for mitigating the dividend allowance cut. You do not incur tax on the income or interest from investments held within an Isa, and when you sell them you do not incur capital gains tax (CGT).

The annual Isa allowance is £20,000 a year, and as you cannot carry forward any unused allowance into future tax years you should use as much of it as you can afford to. Even if your investments don't currently earn more than £2,000 in dividends it is still a good idea to hold them in a tax-efficient wrapper because they could grow or their yield could rise.

"Tax rules change," adds Martin Bamford, managing director of independent financial adviser Informed Choice. "So it's important not to become complacent about the allowances you currently enjoy. Some investors were lulled into a false sense of security after the introduction of the dividend allowance and thought they didn't need to put money into their Isas."

Ms Coles adds: "The £5,000 limit was only around for two years, so there's no saying how long the £2,000 limit will stick around."

If you have not yet used this tax year's allowance, you could invest up to £40,000 into an Isa over the next month in two instalments: one worth up to £20,000 by 5 April, and a second worth up to £20,000 from 6 April.

Bed and Isa

You could mitigate dividend tax via a strategy called 'bed and Isa'. This involves selling income-producing assets held outside tax wrappers and rebuying them within an Isa, making sure you don't crystallise gains worth more than the annual CGT allowance. This tax year the CGT allowance is £11,300 and in 2018/19 it rises to £11,700. You can also offset gains against losses. 

"It's difficult to avoid paying tax on income from investments – particularly after the dividend allowance is cut to £2,000, whereas you have more discretion over how you take capital gains in order to make the most of your annual CGT allowance," says Ms Coles.

If you are going to use bed and Isa, allow enough time to sell and repurchase your investments before the end of the tax year.

Use your pension

You could also shelter dividend-paying assets within a pension via a similar process known as 'bed and Sipp'. As pension contributions are subject to tax relief, bed and Sipp has the added benefit of an immediate 20 per cent tax relief boost for basic-rate taxpayers. And additional and higher-tax taxpayers can claim further tax relief on bed and Sipp, just as with other pension contributions. 

But when you take money out of your pension above the 25 per cent tax-free entitlement, you have to pay income tax on it at your marginal rate. You also can't access the money in the pension until at least age 55. And if you have already done a bed and Isa you may have used up your annual CGT allowance, meaning a bed and Sipp could incur a CGT bill.

"Don't [move assets into a pension] unless you are absolutely sure, especially if you have got substantial assets," says Mr Bamford. "A lot of my clients with substantial assets face problems with hitting the pension lifetime allowance [of £1m]. Be very careful about letting tax decisions on dividends decide where you allocate money to."

Get help from your spouse

Married couples can work together to mitigate the amount of tax they pay on investments, as they can pass assets to each other without incurring tax. For example, if one partner has used up their annual Isa allowance they could pass assets to their spouse who has not used up their Isa allowance, and they could then put them into an Isa using bed and Isa. A similar process can be used with a Sipp. In the current tax year, both you and your spouse are normally able to make pension contributions of up to £40,000, and non-taxpayers can contribute up to £2,880 before tax relief.

If you are at risk of triggering the dividend tax but your spouse has not used their dividend allowance, you could give them assets generating dividends of up to 2,000.

Married couples can also use any differences in their income tax bands to ensure that taxable dividends are paid to the spouse who pays the lowest tax. As dividend tax rates are linked to the rate of income tax you pay, a higher-earning spouse could reduce their income by transferring income-bearing assets to a lower-earning spouse. For example, if a spouse who pays additional-rate tax passes dividend-paying assets to their spouse who pays basic-rate tax, a couple can reduce the amount paid on dividends from 38.1 per cent to 7.5 per cent.

However, once an inter-spousal transfer is made your partner becomes the full, legal owner of the assets. And both partners should understand the impact of holding what individually can look like quite lopsided portfolios.

"You've got to think of your asset allocation as a whole even if it's spread across two portfolios [for tax purposes]," explains Gary Smith, chartered financial planner at Tilney Group. "If one spouse holds all the equities because they are the lower-rate taxpayer and pay less dividend tax, but have quite a low risk appetite, they could feel uncomfortable holding that higher-risk portfolio. So make sure they understand it is likely to be more volatile."

Manage your growth investments

If you cannot get all your assets into a tax-efficient environment using your and your spouse's allowances, prioritise the assets that are likely to incur most tax. So put dividend-producing investments such as equity income shares and funds into Isas and pensions ahead of growth investments.

But don't ignore your growth assets. If your investments are successful you could accumulate large holdings, which could lead to significant CGT liabilities. So if you have the capacity, also try to get these into a tax wrapper, and make use of your CGT allowance to trim large holdings if necessary.