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How UK dividends are taxed

Dividends are taxed more generously than savings interest.

Things have changed as to how UK dividends are taxed.

There are two big developments you need to know about, which came into effect with the new tax year on April 6th.

But first I want to stress that dividends you’re paid within an ISA or pension remain tax-free. You keep everything you’re paid, and you don’t need to declare them to the taxman.

Using ISAs and pensions is therefore key to shielding your income-generating assets from tax for the long-term.

If you own dividend-paying shares outside of tax shelters, such as in a normal share dealing account (or if you own shares in your own limited company, which pays you a dividend) then the situation is different.

Such dividends may be liable for tax, as we’ll see, and the tax rates have gone up.

Dividends are still taxed at a lower rate than general income tax1 but not as favourably as they were before.

Note: In the discussion that follows about taxes on dividends, I am talking about dividends you’re paid outside of tax shelters. Dividends paid within ISAs and pensions are irrelevant and ignored with respect to taxes. For example, when adding up your dividends to see the total you’ve been paid in a particular year, do not include dividends paid in ISAs or pensions. Forget about them for the purposes of tax! (Enjoy them for the purposes of getting rich and someday buying more ice cream).

The dividend tax changes comprise:

  • A new £5,000 tax-free dividend allowance.
  • Higher rates of taxation on dividends where tax is due.
  • The end of the old and confusing tax credit system.

The dividend allowance

There’s now an annual dividend allowance set at £5,000.

Dividends you receive within this allowance are not taxed.

Like other tax allowances, such as the personal allowance for income tax, the dividend allowance runs over the tax year (so from April 6th to April 5th the following year).

The dividend allowance means you won’t have to pay tax on the first £5,000 of your dividend income – no matter what other non-dividend income you have or what tax bracket you’re in.

Indeed the government claims the dividend allowance means most ordinary investors with small portfolios outside of ISAs and pensions will see no change in their tax liability.

As for the old Dividend Tax Credit system, it has been entirely abolished. Forget about it.

Dividend tax rates

What if you receive more than £5,000 in dividends2 in a tax year?

The tax rates on dividends received over £5,000 are now:

  • 7.5% on dividend income within the basic rate band
  • 32.5% on dividend income within the higher rate band
  • 38.1% on dividend income within the additional rate band

These tax rates are payable on the dividends you receive above the £5,000 dividend allowance.

They mean even basic rate taxpayers will pay some tax (7.5%) on dividend income over the £5,000 allowance, compared to the old system under which basic rate payers paid no tax on dividends.

The Treasury has pointed out these rates remain below the general rates of income tax.

But you will certainly pay more tax on your dividends than before if you receive significant taxable dividend income from large unsheltered share portfolios (valued at more than £140,000 on average, according to the Treasury) or if you’re paid big dividends by a limited company (perhaps because you’re a contractor or a director).

What tax will you pay on your UK dividends?

If your dividend income exceeds the dividend allowance, then you’ll pay tax on the portion that’s over the allowance.

This liability will be declared and met through your annual self-assessment tax return.

For instance, if you were paid £6,000 in dividends, then tax will be due on £1,000 of it. (£6,000 minus the £5,000 allowance).

The rate you’ll pay will depend on which tax bracket your dividend income falls into, as listed above.

And this in turn will depend on your other sources of income.

Here’s an example:

Let’s say you have a non-dividend income of £40,000, and receive dividends of £9,000 outside of an ISA or pension.

Of the £40,000 non-dividend income, £11,000 is covered by your personal allowance, leaving £29,000 to be taxed at basic rate.

This leaves £3,000 of income that can be earned within the basic rate limit before the higher rate threshold is crossed.

The dividend allowance covers this £3,000 first, leaving £2,000 of allowance to use in the higher rate band. All of this £5,000 dividend income is therefore covered by the allowance and is not subject to tax.

The remaining £4,000 of dividends are all taxed at higher rate (32.5%).

Refer to the dividend allowance factsheet for a few other examples.

It’s important to remember that if you build a substantial portfolio of dividend-paying shares outside of an ISA or pension, then their dividend payments could eventually add a decent wodge to your total income – enough to push you into a higher tax bracket.

To avoid taxes reducing your returns, portfolios are always best held in ISAs or pensions where possible.

You did fill your ISAs, didn’t you?

Most small investors will not be hit by these higher rates of dividend tax.

The majority invest within ISAs and pensions, and so aren’t liable for tax at all.

And most unsheltered portfolios will be too small to be generating a dividend income above the new dividend allowance.

However there are exceptions who will be hit.

As discussed below, small business owners who have traditionally been paid a big dividend from limited companies will pay more tax – both because they’ll pay a higher tax rate on the dividends from the company, and also because such substantial dividends will quickly chew through their £5,000 dividend allowance.

I know there’s also a cohort of typically older investors who had built up a big portfolio of income shares outside of ISAs and pensions.

For years I have been telling these people to move as much money as they can into ISAs, perhaps by regularly defusing gains to fund their ISA contributions.

The ISA allowance is annual – and it’s a use it or lose it allowance – so you have to build it up over many years.

Yet inexplicably to me, some argued – even in this website’s own comments – that there was no point in doing so, because dividends were at that point not taxed until you hit the higher rate band.

That was true under the old system – and there was perhaps a difficult choice to be made if you had massive cash savings that were also competing for your ISA allowance.

But taxes on dividends were always liable to change. And now they have.

ISA sheltering costs approximately nothing. There’s at most a trivial cost difference to owning shares within an ISA wrapper versus a normal share dealing account, and often none at all.

People who refused to build up ISAs – in order to save a tenner or two a year – are now going to be walloped with a huge tax bill on their unsheltered income portfolios.

I hate to say I told you so. (Truly – I write a blog to try to help people.)

Incidentally, I suspect the newly lowered rates of capital gains tax were partly introduced as a sop to enable some of these wealthy people to begin winding down their unsheltered income-producing portfolios with just a little less pain.

Why was the old system changed?

Chancellor George Osborne reworked the treatment of UK dividends in the Summer Budget of 2015.

I think his main target was to remove features of the regime that enabled the self-employed to use dividends as a more tax-efficient method of remuneration, compared to salaries.

Osborne argued that the change was also necessary to enable him to further reduce the rate of corporation tax.

However even if his main target was contractors and directors, as we’ve seen the new regime applies equally to dividends received from ordinary shares.

The problem with dividends

In making the changes, the Treasury argued the previous system of tax credits on dividends was designed over 40 years ago when corporation tax was more than 50% and the total tax bill on dividends for some people was over 80%.

Since then, however, tax rates including corporation tax have fallen a long way.

The ridiculously obtuse Dividend Tax Credit system that used to confuse people so much was a holdover from those times, too.

As a result, the government wanted to simplify things.

The best news about the changes is the confusing tax credit finally got the chop.

The bad news is those higher effective rates of tax on dividends, which has thrown a spanner into the works of some older people who had designed their portfolios (and retirement plans) based on how dividends were taxed under the previous system.

A £5,000 dividend allowance sounds generous. But under the old pre-2016 system, the implicit ‘allowance’ was as much as £31,786 for somebody who earned no income from non-dividends above their personal allowance

The government seems to hope these changes will reduce the tax incentive to incorporate and remunerate through dividends rather than wages.

As a small company owner, for instance, I’m set to pay thousands of pounds more a year in tax.

However if you’re an everyday wage-earner paid under PAYE and you only have a small share portfolio outside of ISAs and pensions, you could well be a winner due to the new dividend allowance.

I’m skeptical as to how many of you are out there, though.

Small share portfolios – to repeat myself to the point of tedium – should be tucked into ISAs as soon as possible.

Note: I’ve cleaned up the comments below this article to remove any to do with the old way UK dividends were taxed. I’ve left in the spirited discussion that followed the initial announcement of the new dividend allowance and higher tax rates, but please note some got into a muddle in the heat of the moment, so beware of errors!

  1. But remember, companies paying you a dividend have already paid corporation tax on their profits, before a share was paid to you as a dividend. []
  2. Remember: Outside of ISAs and pensions! []

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{ 110 comments… add one }
  • 100 Richard April 15, 2016, 4:51 pm

    @boardgamer – I think what the words “non-taxpayer” can be explained as follows. In prior tax years it was possible, if your income is small enough, to register with your bank to have interest paid gross. Such people were definitely called “non-taxpayers”.

    From 2016-17 everyone has interest paid gross, but there is still a special 0% rate for the first £5,000 of savings interest, provided your non-savings interest is less than £5,000. People for whom this is true may be what they mean by “non-taxpayer’s”. Thus, I figure that someone with only £20,000 bank interest and £4,000 dividends will have no tax on interest because 20,000-11,000-5,000-5,000= -1,000, and they will have 7.5% on £3,000 of dividends. I am thinking here that with regard to interest they get both the £5,000 nil rate band, and the £5,000 personal savings allowance.

  • 101 boardgamer April 15, 2016, 5:04 pm

    @Richard – while I’m grateful for the tax breaks introduced, I can’t help thinking they could have been made somewhat simpler. The current rules are a complete dogs dinner. Your examples are very useful. Thank-you!

    @Investor – I wonder if the “non-taxpayer” statement could be related to how the dividend tax is going to be implemented. I can imagine brokers being told to deduct 7.5% tax from any dividend income greater than £5k, leaving non-taxpayers to reclaim this later from HMRC. Somewhat tenuous, but I can’t think of any other explanation.

  • 102 grey gym sock April 15, 2016, 5:06 pm

    i like Richard’s stack model. it’s quite similar to this MSE post by “polymaff”: http://forums.moneysavingexpert.com/showthread.php?p=70419925#9 (the latter also incorporates the 0% band for interest)

    on Richard’s earlier query (post #76 – March 31, 2016 at 1:45 pm) about equalization:

    1) i think (though i’m not certain) that equalization doesn’t apply when you transfer units to somebody else, only when you have units created/redeemed via the fund manager. (the old mutual document is presumably about the more common creation/redemption process.) similarly, i’ve seen it said that equalization doesn’t apply to ETFs when we buy/sell them second-hand via the stockmarket, though it might apply to institutions who are involved in creating/redeeming shares in ETFs. as with other shares bought second-hand, the entire dividend is taxable income of whoever holds the share on 1 specific date (the record date). i would imagine that the same applies when transferring units in a fund to somebody else.

    2) if equalization did apply, that would not give you any extra taxable income, providing you transferred the units before the ex-dividend date. equalization for funds never attributes taxable income to you when you don’t own the units on the record date; it can only reduce the taxable income that is attributed to you when you do own units on the record date (but only recently acquired the units). this seems pretty illogical to me (and is unlike the accrued income scheme for gilts / corporate bonds, which “works both ways”), but there you go …

    3) your broker/platform will hopefully provide tax certificates to confirm the tax position.

  • 103 grey gym sock April 15, 2016, 5:12 pm

    Richard: the numbers in your last post (#104 – April 15, 2016 at 4:51 pm) are wrong, because the personal savings allowance is £1k, not £5k. if all of your income is interest and dividends, then the first £17k of interest is tax-free, not as much as £20k.

  • 104 Richard April 15, 2016, 5:19 pm

    @grey gym sock – yes, you are right. I momentarily confused the interest and dividend tax free amounts. So someone with only £20,000 bank interest and £6,000 dividends will pay 20% tax on
    20,000-11,000-5,000-1,000= 3,000, and they will have 7.5% on £1,000 of dividends.

  • 105 dearieme April 15, 2016, 11:30 pm

    @Richard, I’m surprised that someone with a taxable income of £26k gets the £5k zero rate band for interest; I had assumed that that band would be reserved for people with smaller annual incomes. We live and learn. It certainly makes the taxation of earnings and pensions look fierce.

  • 106 dr201 July 12, 2016, 3:39 pm

    If i am a non UK tax resident but am the sole shareholder and director of a personal service company in the UK, will i pay any UK tax on the dividends that I draw? These will be subject to tax in my country of tax residence so am wondering if I will be taxed twice? Thanks

  • 107 Ralph July 19, 2016, 5:05 pm

    Assuming the 7.5% or 32.5% dividend tax is payable, is it recoverable against qualifying VCT purchases?

  • 108 Rehel September 2, 2016, 11:17 am

    Hi,
    I have a question. I have been left some shares in a will, however I’ve been told that I wont receive dividends as they have been allocated to someone else, even though I own the shares. I have the right to sell them, to someone else within the company, but I wont receive any money from them until then. How does this work? Presumably I wont be paying tax on them ( until sale ) as I don’t benefit from them, but I’ve just never heard of this before and ideally I would rather receive dividends on my shares than someone else. Any advice would be more than welcome, thank you.

  • 109 Darren December 23, 2016, 10:41 pm

    1. If I purchase an ETF outside of an ISA – say for GBP 1000 and it increases in value to GBP 1500, then I presume that this comes under CGT and not ‘UK Tax-free Dividend Allowance’, so if I’m a UK resident and UK income earner, then I pay CGT, right ?

    2. What if I sell the ETF and I’m a non-resident ?

  • 110 IanH June 15, 2017, 9:54 pm

    I’m selling my property and plan to invest the capital to generate an additional income alongside a pension. It seems possible that dividends on the investments could take me into the higher rate bracket if the dividend yield is about 3%. I’m wondering if there are index funds that have predictably low dividends and are growth focussed, so I can maybe produce income partly from selling equity too, and use my capital gains allowance before I get into the higher rate region, and pay cgt on larger sums if I have to as it has a lower rate than the higher rate dividend tax.

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