Changes to the way dividends are taxed
There is a Dividend Tax rate of 10% for basic rate taxpayers, and 32.5% for higher rate taxpayers. Additional rate taxpayers have a 37.5% Dividend Tax rate.
In addition to this, there is a 10% Dividend Tax Credit, which cancels out the tax on dividends for those in the basic rate category. For those in higher tax brackets, the Dividend Tax Credit doesn’t cancel out the amount of tax owed but does reduce it slightly.
How are dividend taxes changing?
From April 2016, Dividend Tax Credits at 10% will no longer exist. Instead, each person receiving dividends will receive a £5,000 tax-free allowance, no matter how much they earn. Dividend recipients will no longer need to pay tax on the first £5,000 of their dividend income, but will be taxed on any dividend income that is received above the initial £5,000.
In the basic rate band, dividend income will be taxed at 7.5%. This means that those in a previously tax-free band may now have to pay some tax on their income from dividends. The rate remains at 32.5% for the higher rate band and changes to 38.1% for the additional rate band. Your usual tax allowance (£11,000 in April 2016) will still exist.
How will the change affect dividend recipients?
The new system is easier to understand, and will also be easier to implement. A static £5,000 allowance across the board allows for a simple calculation, with clear tax rates for the various bands once this allowance has been used up.
A couple of examples:
Person A receives a salary of £8,000 and a dividend income of £16,000. £3,000 of that dividend income is covered by their tax allowance and another £5,000 is covered by their tax free allowance for dividends, leaving £8,000 to be taxed at 7.5%.
Person B receives a salary of £20,000 and a dividend income of £40,000. The total income of £60,000 puts Person B into the higher tax bracket (starting at £32,001). Person B’s personal allowance will not cover any of their dividend income, but they’ll still receive a dividend tax allowance of £5,000 which will leave £35,000 of their dividend income subject to tax payments. The basic rate band for taxes stops at £32,000 which means that £12,000 of Person B’s dividend income will be taxed at 7.5% and the remaining £23,000 will be taxed at 32.5%. These rates are lower than the tax rates on non-dividend income, which would stand at 20% and 40% respectively.
Worth noting is the fact that Person A would previously not have paid any tax on their dividend income, but is now paying 7.5% on a portion of it. Person B would have paid approximately £4,963 of dividend tax in the 2015/16 financial year, but would need to pay £6,875 in the 2016/17 financial year, resulting in additional taxes on dividends of just over £1,900. The new system will make for easier calculations, but will leave many people paying a higher dividend tax.
What other impact will the new system have?
- Sole traders have often seen tax benefits as the main reason to form a Limited Company, if they’re in a position to comfortably choose between the two. Being able to take a small salary and ‘top up’ their income using dividends has certainly been appealing to some. Now, the tax savings still exist but are less significant than they were. Other benefits and drawbacks will be even more worthy of consideration in the future.
- Company directors will, more than ever, want to look into other options for keeping their tax bill down. ISA allowances can help, as can the potential option for a spouse to be brought into the company as a shareholder or director to take advantage of income splitting. In these cases, it’s particularly important to discuss options with the company’s accountant to avoid any complications and potential broken laws.
- Many people previously not paying tax due to the combination of a personal allowance and Dividend Tax Credits will, under the new system, end up paying tax. This may also bring them into the Payments on Account system, which requires up-front payment of taxes. In the first year in particular, this can be a shock with payment due for last year’s tax along with a 50% payment on account for next year’s.
What help is available to cope with dividend tax changes?
A good accountant will be able to work with you to talk through your options and to find the most tax effective route under the new system, for your company and your unique circumstances.
You should also make sure that your HR Manager, or Human Resources department, is keeping accurate and up to date records regarding salaries and payments. These are details which will be required by your accountant in order to plan a course of action. Using HR software will enable you to store important documents securely and safely, to be accessed only by those that need the information.