In 2016, the UK introduced significant changes to dividend tax. The notional 10% Dividend Tax Credit was replaced by a 0% tax rate on the first £5,000 of dividends. This annual tax-free allowance has since been reduced to £2000, resulting in a considerable tax hike for many small company directors and shareholders who normally take a large chunk of their annual remuneration as dividends.
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.
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 (NIC) 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 the changes to dividend tax, UK residents now pay the following rates of dividend tax on annual dividend income above £2,000 (2021/22 tax year):
- 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 £14,570. This is made up of £12,570 salary + £2,000 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 (PA)
- You will pay 12% Class 1 National Insurance on your salary between £9,568 (NIC Primary Threshold) and £12,570 (PA)
- The company will pay 13.8% Class 1 Employers’ NI on your salary between £8,840 per year (NIC Secondary Threshold) and £12,570
Example 2:
You receive a total annual income of £50,000. This is made up of £12,570 salary + £37,430 dividends:
- You are a basic-rate taxpayer
- You won’t pay any personal tax on the first £2,000 of dividends, nor will you pay any Income Tax on your salary
- You will pay 12% Class 1 NIC on your salary between £9,568 and £12,570
- The company will pay 13.8% Employer’s NI on your salary between £8,840 and £12,570
- You will pay 7.5% dividend tax on the remaining £35,430 of your dividend income
Example 3:
You receive a total annual income of £55,000. This is made up of £12,570 salary + £42,430 dividends:
- You are a higher-rate taxpayer
- You won’t pay any personal tax on the first £2,000 of dividends, nor will you pay any Income Tax on your salary
- You will pay 12% Class 1 NIC on your salary between £9,568 and £12,570
- The company will pay 13.8% Employer’s NI on your salary between £8,840 and £12,570
- You will pay 7.5% dividend tax on £35,430 of your dividend income, and 32.5% dividend tax on the remaining £5,000 of dividend income
Is dividend income covered by my Personal Allowance?
Yes, if you take dividends of £14,570 in the 2021/22 tax year and do not receive income from any other sources, you will not pay any personal tax. The first £12,570 is covered by your Personal Allowance, and the remaining £2,000 is covered by the tax-free dividend allowance.
How will these changes affect ISAs and Pensions?
If you receive dividends on shares held in an ISA, this income is still tax-free under the new regime. This means that you can save £20,000 of dividend income in an ISA during the 2021/22 tax year.
Additionally, the changes to dividend tax have not affected the rules for pensions. 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 line with the pension withdrawal rules that exist at that time.
