A new dividend tax came into effect on 6th April 2016 in a bid to deter tax-minimising strategies and incentivise more people to invest their dividend income instead. The notional 10% Dividend Tax Credit, which baffled a great many people, has been replaced by a 0% tax rate on the first £5,000 of annual dividend income.
It is estimated that around 1 million directors and shareholders of UK limited companies will be unaffected or pay less tax on their divided income. However, the changes will have a significant impact on small business owners who are basic-rate taxpayers and take a large chunk of their annual remuneration as dividends.
Higher and additional rate tax payers will also pay more dividend tax above the £5,000 allowance, but they will benefit from the changes if they receive less than £5,000 dividend income per year. Under the old regime, higher rate taxpayers paid 25% tax on all dividend income, so they will now save £1,250 on this £5,000. Additional rate taxpayers would have paid 30.56% tax (£1,528) on this £5,000.
Whilst the limited company structure is still more tax efficient than operating as a sole trader, the gap between potential tax savings has narrowed significantly in light of these changes. As always, speak to your accountant as soon as possible to discuss the best strategy for the current tax year.
New dividend tax rates
Prior to these changes to dividend tax rules, basic-rate tax payers were able to avoid paying Income Tax and National Insurance Contributions on their entire dividend income, whilst higher-rate and additional-rate tax payers were required to pay 32.5% (effective rate of 25% after 10% tax credit) and 37.5% (30.56% after 10% tax credit), respectively, on their dividend income above the basic-rate threshold. As a result of these new rules, UK residents will now pay the following rates of tax on annual dividend income above £5,000:
- Basic-rate tax payers: 7.5%
- Higher-rate tax payers: 32.5%
- Additional-rate tax payers: 38.1%
Example 1:
You receive a total annual income of £16,500. This is made up of £11,500 salary + £5,000 dividends:
- You are a basic-rate taxpayer. You won’t pay any dividend tax, nor will you pay any Income Tax on your salary because it’s within your tax-free Personal Allowance.
- You will pay 12% Class 1 National Insurance on your salary between £8,164 (NIC Primary Threshold for 2017-18) and £11,500.
- The company will pay 13.8% Class 1 Employer’s NI on your salary between £8,164 (Secondary Threshold for 2017-18 tax year) and £11,500.
Example 2:
You receive a total annual income of £45,000. This is made up of £11,500 salary + £33,500 dividends:
- You are a basic-rate taxpayer.
- You won’t pay any tax on the first £5,000 of dividends, nor will you pay any Income Tax on your salary.
- You will pay 12% Class 1 NIC on your salary between £8,164 – £11,500.
- The company will pay 13.8% Employer’s NI on your salary between £8,164 -£11,500.
- You will pay 7.5% dividend tax on the remaining £28,500 of your dividend income.
Previously, this dividend income would not have attracted tax, so a small company owner who is within the basic rate tax bracket will now be £2,025 worse off within this scenario.
Example 3:
You receive a total annual income of £55,000. This is made up of £11,500 salary + £43,500 dividends:
- You are a higher-rate taxpayer.
- You won’t pay any tax on the first £5,000 of dividends, nor will you pay any Income Tax on your salary.
- You will pay 12% Class 1 NIC on your salary between £8,164 – £11,500.
- The company will pay 13.8% Employer’s NI on your salary between £8,164 – £11,500.
- You will pay 7.5% dividend tax on £28,500 of your dividend income, and 32.5% dividend tax on the remaining £10,000 of dividend income.
Is dividend income cover by my Personal Allowance?
Yes. If you take receive £16,500 of dividend income in the 2017-18 tax year and do not receive income from any other sources, you will not pay any tax. The first £11,500 is treated as your Personal Allowance, and the remaining £5,000 is covered by the dividend allowance.
How will these change affect ISAs and Pensions?
If you receive dividends on shares held in an ISA, this income will continue to be tax free under the new regime. This means you can save £20,000 of dividend income in an ISA during the 2017-18 tax year.
The rules for pensions also remain unchanged. Dividend income received in a pension fund will continue to be tax free whilst this money remains in the pension. When this income is withdrawn, the dividends will be taxed in one with the pension withdrawal rules that exist at that time.