Changes to the way dividends are taxed stand to leave investors exposed to an unwelcome tax charge from April. Investors can mitigate this risk by making the most of all their available tax-free allowances.
The government has been tweaking the rules surrounding dividend income for a while now. In 2015, it was announced that the Dividend Tax Credit would be replaced with a £5,000 allowance from April 2016. Now, investors are about to be subject to another change to the rules. From April, the amount in dividends that investors are entitled to collect, tax free, will be cut from £5,000 to £2,000.
Any dividends received in excess of this will be taxed at 7.5% for basic rate payers, 32.5% for high rate, and 38.1% for additional rate. For investments held outside of a tax-efficient wrapper, this clearly has the potential to create a new tax liability.
The key to managing this reduction is understanding how HMRC classifies income in order to make the most of all available tax exemptions. Funds which invest more in equity are generally the ones which pay dividends. Authorised unit trusts, open-ended investment companies and investment trusts which have a high allocation to fixed income typically pay interest. For example, the CS Monthly High Income fund has a 60% allocation to fixed income and pays interest. This also applies to income from government or corporate bonds as well as most types of purchased life annuity payments.
These distinctions will need to be confirmed with the fund provider in question but it is a good rule of thumb.
Once you have established whether the dividend allowance will affect your investment income, you can consider whether it would make sense to reallocate in favour of a separate tax allowance which was introduced in April 2016. The Personal Savings Allowance currently stands at £1,000 for basic rate taxpayers, reducing to £500 for higher, and is eliminated entirely for additional rate taxpayers. It cannot be applied to dividend distributions but it does apply to interest.
If income is a priority, you may consider switching up your portfolio in order to make the most of all available allowances. Investors who currently expect to collect around £3,000 in dividends from April, for example, could work around the rules by selling a portion of their portfolio in order to bring this down to £2,000 – within the new limit. Investors can separately aim to collect that £1,000 difference in interest from an income fund without incurring a tax charge.
Diversification is key to any successful investment strategy and this example demonstrates how the principle can also be leveraged to ensure tax-efficiency. The scenario is not without its limits, however. An investment of £23,000 into the CS Monthly High Income fund would be enough to maximise the personal savings allowance for a basic rate taxpayer.
If you are thinking about selling investments, remember that anyone can realise up to £11,300 in capital gains every year without incurring a tax charge and previous losses can be carried forward indefinitely. If the assets are jointly owned, you can combine your allowance with your spouse’s and realise £22,600 in capital gains. This also provides an opportunity to move your investments into a tax-efficient wrapper like an ISA.
The rules on taxation are always changing and it’s important to keep up with these developments in order to make sure you are not paying more tax than you have to. The solutions will differ from person to person but the main thing is to take advantage of every exemption available that fits your profile.
Nothing in this article should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal. Levels of taxation depend on individual circumstances and maybe subject to change in the future. The information contained within this article is based on our understanding of current UK Legislation, Taxation and HMRC guidance, all of which may be subject to change.