Understanding the taxation of dividends is crucial to giving the right advice to both investors and business owners. This is especially true now following the changes to taxation seen last year and the upcoming cut in the dividend allowance. So here is a brief run-through of the main rules.
The dividend allowance, introduced last year, was one of the biggest changes in this area of advice. And it is to change again in a year’s time. At the moment, it means the first £5,000 of dividends you get are taxed at nil per cent. From 2018/19 this reduces to £2,000. Simple enough.
But using the word “allowance” in this context is a bit misleading. This is because it is not like the personal allowance; it does not create a slice of income that pushes up the point at which the basic rate tax band starts.
If all your income were dividends, the first £11,500 would be free of income tax because of the personal allowance. The next £5,000 would be tax-free thanks to the dividend allowance. Above that, your dividends would be taxed at 7.5 per cent up to the higher rate tax threshold of £33,500 on top of the personal allowance.
There are three points to note. First, the dividend allowance is set against the basic rate band in this case; not the personal allowance. Secondly – and importantly for Scots – their lower higher rate band threshold of £31,500 does not apply to dividends. Thirdly, the dividend allowance reduced the tax by just £375 on £5,000 at 7.5 per cent.
To see how this can work at a higher rate, we need to look at a situation where you have a mix of non-dividend income. It is important to remember the priority rules for taxing different types of income. The essential order is:
- Earnings and other non-savings non-dividend income
- Savings income, such as bank interest
For example, if you had earnings of £50,000 and dividends of £20,000, the tax position on this total income of £70,000 would be as follows:
- The first £11,500 would taxed at nil – covered by the personal allowance
- The next £33,500 of the earnings would be taxed at 20 per cent – the basic rate of tax on earned income
- The remaining £5,000 of earnings would come into the higher rate tax band and be taxed at 40 per cent, the higher rate of tax on earnings
The dividends are then subject to tax and also fall within the higher rate tax band:
- The first £5,000 of dividends is covered by the dividend allowance and is tax free
- The remaining £15,000 of dividends is taxed at the special higher tax rate on dividends of 32.5 per cent
In this case, the dividend allowance is set against the first £5,000 of dividends that would otherwise be taxed at 32.5 per cent, saving £1,625 in tax. If your first £5,000 of dividend income happened to fall within the additional tax band, it would save tax at the rate of 38.1 per cent or £1,905. So the higher your non-dividend income pushes you up the rate bands, the more valuable your allowance is.
Remember, then, that the dividend allowance has no effect on the size of the rate bands. It just means the first £5,000 of your dividend income is taxed at nil and the rest is taxed at whatever rates of tax would apply to your dividends.
Measure the cut’s impact
This structure of taxation will make a big difference to how the April 2018 dividend allowance cut from £5,000 to £2,000 will affect different types of clients.
Some will find it has relatively little impact. Strangely this could be taxpayers with very substantial dividend incomes. These are the owner/managers of small companies with little or no other income. These people normally draw out remuneration up to the National Insurance contribution threshold (£8,164 this year), then draw dividends from the company profits for the rest of their pay.
Using 2017/18 rates, this would mean the dividends would be covered by the rest of the personal allowance up to £11,500. The dividend allowance would then kick in above £11,500, saving 7.5 per cent dividend tax.
So this year, the value of the allowance for a basic rate taxpayer is £375: 7.5 per cent of £5,000. Next year, the value of the allowance will be worth just £150: 7.5 per cent of £2,000. While that is a big reduction in percentage terms, the absolute reduction of £225 is not huge.
However, for those whose dividends are taxed at much higher rates, the cut in the dividend allowance will make a much greater difference to their net income. For instance, someone with dividends who has a high level of non-dividend income too (for example, from earnings, pensions, rents, deposit interest) could lose out much more.
A higher rate taxpayer with dividends whose non-dividend income exceeds the higher rate tax threshold (typically £45,000 this year) will see a reduction of £975 in net income. Someone with dividends and non-savings income of at least £150,000 (taking them into higher rate tax) will see a reduction in net income of £1,143.
Danby Bloch is chairman at Helm Godfrey