New tax year, new rules

David Prosser explains the new tax system for dividends from stock market investments. 

From 6 April, the first day of the 2016-17 tax year, the dividend income investors earn from their stock market investments will be taxed according to a new system unveiled by the Chancellor in his post-election Budget last summer. If you’re invested in investment companies, many of which have an excellent long-term track record of paying rising dividends, you’ll need to get to grips with the rules.

The good news is that the new system is simpler than the one it replaces – and many people won’t pay any more tax (some may even pay less). For others, however, higher tax rates will apply, and they’ll need to think about how to plan for the increasing bill.

Until now, dividends paid on shares, including shares in investment companies, have come with a notional 10 per cent ‘dividend tax credit’ attached. Basic-rate taxpayers have not had any tax to pay on their dividend income, while higher-rate and additional-rate taxpayers have had to declare this money through their self-assessment tax returns and pay income tax on it at rates of 25 per cent and 30.55 per cent respectively.

Now, however, the dividend tax credit is being abolished and new tax rates will apply. Basic-rate taxpayers will be liable to income tax on their dividends at 7.5 per cent, while the new rates for higher-rate and additional-rate taxpayers are 32.5 per cent and 38.1 per cent.

If that sounds like bad news, the silver lining is that everyone will be entitled to receive £5,000 of dividends each year without paying a penny of tax on the money, no matter how much they receive in other types of income, such as salary or pension. As long as the dividend income you receive on all your shares, including your investment companies, does not total more than £5,000 over the course of the tax year, you won’t have to declare the money through self-assessment, or pay any income tax on these dividends, even if you’re normally a higher-rate or additional-rate taxpayer.

Winners and losers

Overall, anyone with less than £5,000 of dividends isn’t going to have to worry about their tax bill increasing under the new system, because they’ll simply pay no tax at all. Basic-rate taxpayers who didn’t previously have to pay tax on dividends, but have more than £5,000 of this income, will have to pay tax for the first time above the threshold. Meanwhile, higher-rate and additional-rate taxpayers will be better off if their dividends total less than £5,000, but will have to pay tax at higher rates on income above this level.

If you have investment company shares you now fear will be affected by higher tax on dividends, it may be worth considering putting them inside an individual savings account – or, indeed, making future investments of this type within an ISA. All dividends received on investments inside ISAs are tax-free, no matter what their value or what tax rate you normally pay income tax at.

It’s also important to plan ahead. You may not be affected immediately by the new system, but over time, as your investments build up and dividends increase – many investment companies have raised dividends every year for an extended period – tax may become more of an issue. Using ISA allowances on an ongoing basis will then prove valuable, since each year’s allowance is only worth so much (£15,240 in 2016-17) and can’t be carried over.