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Have you been caught out by dividend tax changes?

Written by: Chris Aitken
Significant numbers of investors may be paying more than they need to as a result of changes to dividend tax. Chris Aitken of Investec Wealth & Investment explains the new rules and how to cut your tax bill.

A large number of people are affected by changes to the dividend tax allowance, including individuals with portfolios generating taxable dividend income in excess of £5,000 per year.

Other groups affected are owners of private limited companies who pay themselves by way of dividend, and trustees of discretionary trusts invested in assets generating taxable dividends.

Before 6 April 2016, dividends were paid with a 10% non-reclaimable tax credit. It assumed that the basic rate of tax had already been paid but for higher rate payers, they had an effective rate of 25%.

After 6 April, the 10% non-reclaimable tax credit was removed.

All individuals have a dividend allowance of £5,000 per tax year, which means investors will not pay tax on the first £5,000 of dividend income.

The dividend allowance is in effect a ‘zero rate band’ because dividend income is still regarded as income for the purposes of assessing where other income sits within the various income tax bands.

Above the new £5,000 allowance, dividend income will be taxed at the following rates:

  • Basic rate taxpayer – 7.5%
  • Higher rate taxpayer – 32.5%
  • Additional rate taxpayers and trustees – 38.1%.

Those worse off by the change include basic rate taxpayers with dividends over £5,000, higher rate taxpayers with dividends over £21,667 and additional rate taxpayers with dividends over £25,250.

How to cut dividend tax

For people affected by the changes, there are some specific planning opportunities available to mitigate their impact. These include use of tax efficient investments such as ISAs, pensions and offshore bonds, and Venture Capital Trusts (VCTs), as well as use of inter spouse exemption and personal allowances.

Under the previous system, a basic rate tax payer had no further additional income tax to pay on taxable dividends received. This is because the 10% tax credit was deemed to have satisfied an individual’s basic rate tax liability.

Where a married couple, one a basic rate taxpayer and the other a higher rate taxpayer, held an investment portfolio which produced taxable dividends, it was tax efficient for the basic rate taxpayer to receive the taxable dividends.

The new system potentially changes this where the taxable dividends exceed £5,000 per year. The excess over £5,000 will now be taxed at 7.5% for a basic rate tax payer. For example, if a basic rate tax payer is in receipt of £10,000 per year of taxable dividends, under the previous system, no additional tax would be due. However, under the new system, £5,000 would be zero rated (no tax) but the excess of £5,000 would be subject to 7.5% tax, or £375.

By moving sufficient investments generating up to £5,000 in dividends to the higher tax paying spouse, the excess would now fall within the other spouse’s dividend allowance, so again would be zero rated, so no tax liability.

In the above example, this would again ensure that the £10,000 of dividends would not generate a tax liability under the new system.

Care should be taken not to exceed the new dividend allowance of £5,000 for the higher tax paying spouse as the excess would generate a higher liability for them of 32.5% for a higher rate tax payer or 38.1% for an additional rate tax payer.

Investors should also consider a spouses other income as reallocation could impact upon where this income sits within the basic/higher/additional rate bands.

Chris Aitken is head of financial planning at Investec Wealth & Investment

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