The new dividend tax allowance explained

Gareth Shaw / 22 March 2016 ( 05 April 2017 )

The tax rate on shares and dividends is undergoing yet another change. So, follow our guide to the winners and losers.



Question

I’ve built up some savings in shares and funds that invest in shares. Will I benefit from the dividend tax allowance that’s coming into force this month?

Answer

Dividends are every investor’s secret weapon. 

When you own shares in a company, you may think that the only way to make a profit is for you to sell the shares at a price higher than when you bought them. But during the time between buying and selling, dividends have the potential to pay you a very handsome and regular income. 

A dividend is essentially the distribution of the profit a company makes to its shareholders, paid twice a year, and usually expressed in pence per share.

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Dividend yield

Let’s dive a bit deeper. 

Say you hold 1000 shares in a company, and it pays a dividend of 5p; that translates to an income of £50. And an important figure to look out for is the ‘dividend yield’ of a company. This is a percentage, and shows the proportion of the dividend paid against a company’s share price. 

Say your shares in the example above are worth 200p each. That means your 5p dividend translates to a 2.5% dividend yield, giving you an idea of the kind of income that dividends could pay you.

Of course, as with any income you earn, there’s tax to pay. And with the beginning of the new tax year this month, there are some significant changes. 

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New tax-free dividend allowance

If you own shares, or funds that invest in shares, you’ll be affected. And, as in most HMRC changes, there are winners and losers.

First, the good news: from April 6, 2015, every investor was handed a new £5,000 tax-free dividend allowance. The bad news is that in the 2017 Budget, Chancellor Phillip Hammond cut this to £2,000 - the change will take place in April 2018.

That means until April 2018, you’ll be able to earn up to £5,000 a year from dividends completely free of dividend income tax.

At the moment, you would need a chunky amount invested in shares to earn £5,000 a year. The dividend yield on the FTSE 100 index – which measures the performance of the shares of the biggest companies in the UK – is currently around 4%. You’d need £125,000 worth of shares to generate £5,000 in dividend income.

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Increase in tax rates on dividends

If you do earn more than the tax-free allowance, the amount of tax you pay is going up. 

For basic-rate taxpayers (those who earn between £11,000 and £43,000), you’ll pay an extra 7.5% on any dividend income earned above £5,000.

Higher-rate taxpayers (those earning between £43,000 and £150,000 a year) will pay 32.5%, an increase from 25% under the old rules. You’ll start paying more tax than you used to when you earn dividends above around £21,600, with the new tax-free allowance included. 

For additional-rate taxpayers, the tax rate increased from 30.6% to 38.1%, and you’ll pay more tax once you earn more than £25,400 worth of dividends.

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What should I do?

It might be tempting to think that, with the new tax-free allowance, there’s no need to hold shares inside your ISA, in which you can earn dividend income tax free. 

However, while the new tax-free allowance means you don’t have to pay dividend income tax, you may still face a capital gains tax (CGT) bill if you sell your shares for a profit. This could be either 18% or 28% of the profits you make above £11,100, depending on how much you earn.

It still makes sense, therefore, to use your full stocks and shares ISA allowance of £20,000 as the first port of call. But it could pay to think tactically about where you hold your investments. 

If, for example, you hold shares or funds designed to pay you a regular income and not necessarily to grow your investments, these might be best held outside your ISA to take advantage of the new allowance. 

Meanwhile, investments designed for growth over the long-term, which don’t necessarily pay dividends, could be held in an ISA to save on CGT.

Money expert Paul Lewis on the dividend tax raise:

From April 2018, the Chancellor is slashing the tax-free allowance for dividend payments on shares from £5,000 to £2,000. The £5,000 allowance began only in April 2016 and meant many people paid no income tax on the dividends their shares earned. 

The cut in allowance will cost basic-rate taxpayers up to £225 a year and higher-rate taxpayers up to £975 a year extra tax. 

The change makes it even more important to put your shares into an ISA where no tax is charged on the dividends they earn. In the 2017/18 tax year you can put up to £20,000 into one.

 So if your investments are not all in ISAs, it may be worth starting now. Check charges and seek independent financial advice.

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The opinions expressed are those of the author and are not held by Saga unless specifically stated.

The material is for general information only and does not constitute investment, tax, legal, medical or other form of advice. You should not rely on this information to make (or refrain from making) any decisions. Always obtain independent, professional advice for your own particular situation.