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.
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!