The existing rules
Under existing legislation, the taxation of dividends is made complicated due to a 10% tax credit being added to the cash amount of the dividend, with the tax credit then satisfying all or part of the income tax liability on the dividend.
The practical effect of the system is that basic rate taxpayers have no further tax to pay on dividend income and a higher rate taxpayer will pay an effective 25% on the cash amount of the dividend receipt. However, this is soon to change: from 6 April 2016 this tax credit will cease, and all dividend income will be taxed as gross.
Changes from April 2016
From April 2016, the dividend tax credit will be replaced by a new tax-free Dividend Allowance. This means that for the 2016/17 tax year you will have the first £5,000 of dividend income taxed at 0%, regardless of the level of non-dividend income.
Headline rates of dividend tax are also changing, with tax charged on dividends received over £5,000 at the following rates:
- 7.5% on dividend income within the basic rate band (ordinary rate)
- 32.5% on dividend income within the higher rate band (upper rate)
- 38.1% on dividend income within the additional rate band (additional rate)
If your dividend income moves you from one tax band to another, then you will pay the higher dividend rate on that amount. Investors with modest income from shares will see either a tax cut or no change in the amount of tax owing.
The Dividend Allowance will not reduce total income for tax purposes, and dividends within the allowance will still count towards the appropriate basic or higher rate bands. They may therefore affect the rate of tax payable on dividends received in excess of the £5,000 allowance.
Dividend changes: a comparison
The following table shows a comparison between the current and prospective tax rates:
Andy has non-dividend income of £6,500 and a dividend income of £12,000 outside of an ISA.
In the current tax year, Andy will have no tax to pay on his dividend - some of the dividend falls into the basic rate band but the effective tax rate is nil.
Next tax year, Andy’s personal income tax allowance of £11,000 covers his non-dividend income plus £4,500 of his dividends. With the £5,000 dividend allowance, he will pay tax on £2,500, which is at 7.5% as he is a basic rate taxpayer.
Winners and losers
Depending on your overall income and dividends you expect, this change may have a greater or lesser impact on your finances.
An example of a winner is a higher rate taxpayer who has dividend income of £5,000. In the current tax year he will have a tax liability of £1,250 (25% of £5,000). Next year he will have no tax liability.
An example of a loser under the regime will be the sole shareholder of a company who takes a small salary and then dividends up to the threshold at which higher rate tax is payable. In the current tax year he has no income tax on the salary (as the salary is below the personal allowance) and no tax on the dividend. Next year only £5,000 of the dividend will not be taxable.
Points to consider
Be sure to make the most of your tax-efficient savings and pension options. Married couples could consider spreading their investment portfolios in order to maximise the dividend tax allowance, and also make use of their personal income tax allowances.
Other points to note:
Trading as a limited company
If you are currently trading as a limited company most individuals still benefit in tax terms. The tax saved by incorporation has, however, been reduced.
Salary or dividend
A director-shareholder is still likely to benefit from taking a dividend over a salary, although the amount of tax saved will be reduced.
Taking dividends before April 2016
It may be worth increasing dividends before 6 April 2016. However, there may be other tax issues to consider, such as loss of the personal tax allowance if your total ‘adjusted net income’ exceeds £100,000.
Please note that this is based on our current understanding of the new regime. However planning at this stage can help save you money in the future, so please contact us for advice tailored to your particular circumstances.