Not many people enjoy change, especially when it means doing things differently. When it comes to investing however, change is inevitable. Assets go up as well as down and the government regularly introduces new rules concerning taxation and regulatory matters. Sometimes these grab headlines, as they did this past summer with the Budget. The chancellor introduced the new ‘living wage’, increased childcare provision, reduced corporation tax further and increased the personal allowance and higher-rate tax thresholds. While these changes have been heavily debated, the Chancellor’s announcement to bring about major reforms to the taxation of dividends received little attention. It might surprise you to know that Osborne’s revenue-raising dividend tax changes that will come into effect in April 2016 actually benefit high-rate taxpayers and, when considered wisely, provide an opportunity for future tax-free savings.
There will be both winners and losers when the £5,000 annual dividend allowance is introduced in April. Higher rate taxpayers could be better off by up to £1,250 per year (£1,530 for additional rate taxpayers) while some basic rate taxpayer could be worse off by as much as £2,025.
How Much Will The Dividend Tax Changes Affect Investors?
From 6 April 2016 the method for taxing dividends received by individuals will change. The 10% tax credit will disappear. Instead, the first £5,000 of dividend income will be tax free for everyone. In addition, tax rates exceeding this allowance will also change based on the table below:
| Current Tax Year | Next Tax Year | |
|---|---|---|
| Non-taxpayers | 0% | 0% |
| Basic rate payers | 0% | 7.5% |
| Higher rate payers | 25% | 32.5% |
| Additional rate payers | 30.56% | 38.1% |
Most basic rate taxpayers will be no worse off than this year, unless they have dividends in excess of £5,000. While £5,000 should be sufficient to cover the dividends for most basic rate taxpayers they will have to pay an additional 7.5% on amounts over the allowance from next April.
The real winners are higher rate taxpayers who will be better off by £1,250 and additional rate taxpayers who will be better off by £1,530 with dividend income of less than £5,000 each year.
There is a tipping point where the tax savings on the first £5,000 are outweighed by the higher rates of tax imposed on dividends in excess of the allowance. That point arrives when dividends hit;
- £21,660 for higher rate taxpayers, and
- £25,400 for additional rate taxpayers.
Individuals with dividends below these figures are still better off, while individuals with dividends above these figures will pay more tax.
It is important to note that the full amount of dividend received, even if covered by the £5k allowance, will still count towards total income when determining income and capital gains tax rates, as well as entitlement to the personal allowance.
The abolition of the 10% credit will not affect the of amount dividend that is distributed. The tax credit was only ever a notional credit – 10% tax is not deducted on distribution. The credit merely reflects the fact that the dividend was paid out of a company’s profits after corporation tax. So investors will receive exactly the same amount.
But how dividends are taxed will change. No tax credit means no more grossing up is required. The amount received is the amount subject to tax, with the first £5,000 of dividends tax-free (note: if an investor has unused personal allowance, dividends would be used against this first – so these individuals could receive even more than £5,000 of dividends tax free).
An Opportunity for Tax Free Savings
All these changes present an opportunity for investors to build up a tax free fund alongside their ISA, simply by using the allowances available to them.
This can be achieved by investing in a ‘General Investment Account’ individual shares or ‘mutual funds’ and keeping dividend income to below £5,000pa, and releasing capital gains annually from one’s portfolio within the annual Capital Gains Tax (CGT) exemption (£11,100 for 2015/16).
The portfolio value at which no tax will be due will of course depend on performance. The following table compares different portfolio types:
| Portfolio size | Dividend Yield | Tax free income | Cap. growth rate | Tax free growth |
|---|---|---|---|---|
| £200,000 | 2.5% | £5,000 | 5.5% | £11,100 |
| £400,000 | 1.25% | £5,000 | 2.75% | £11,100 |
| £500,000 | 1% | £5,000 | 2.22% | £11,100 |
Of course, any re-allocation of assets to achieve income and gains at these levels would also have to be appropriate your risk profile.
Savings Order
Purely on the basis of tax, and all things being equal (e.g. investment funds, charges), the order appropriate for most people would be:
1. Pensions
The combination of tax relief on contributions, tax free investment returns and the ability to take a quarter of the fund tax free mean pensions will like for like outperform other tax wrappers.
2. ISAs (Individual Savings Accounts)
With tax free investment returns and unrestricted access, ISAs will remain the next best thing to a pension.
However, for many they may still be the vehicle of choice because of their simplicity, where funds may be needed before age 55, or where the client needs an ’emergency’ fund.
3. Equity Unit Trusts, OEICs General Investment Accounts and Individual Shares
The new dividend allowance makes a compelling argument for building up a collective portfolio where income and gains can be managed within the £5,000 dividend tax allowance and the £11,000 CGT allowance. The result would be a ‘quasi’ ISA which has been built up without a tax drag, and importantly which could be accessed in the future without a tax charge.
4. Offshore Bonds
Offshore bonds defer the tax charge until surrenders are taken, thus the dividend tax and any capital gains are sheltered until maturity or surrender. When this happens, bond holders are taxed at their highest marginal rates of income tax (20%, 40% or 45%) on the bond gain. However you can take the bond profits at a time when you are non-taxpayers.
To maximise the benefits of a bond, the trick is to extract at 0% tax, for example as a bridging pension by deferring taking benefits from pension plans, or assigning to non-taxpayers such as grandchildren at university who can cash in to finance their studies. If this can’t be achieved speak to your Quadrant Group adviser about ‘top slicing’.
Conclusion
These changes may trigger a review of existing investments. Of course, any future tax savings by changing investment wrappers must be balanced against any immediate tax charges as a result of disinvestment. Considering a phased strategy of disinvestment across a number of tax years may be needed to maximise the use of available allowances and reduce the tax payable.
At Quadrant, we understand that change brings challenges and opportunities for investors. This new dividend allowance means individuals can extend their tax free savings capability, albeit with careful monitoring and advice and keeping in mind that for most people pensions and ISAs will still be the first port of call for savings.
If you would like to learn more about how the summer budget will impact your wealth and how we can help you to make the most of these changes, please get in touch.
Data within this post was published with the permission of Standard Life and is based on my understanding of current tax rules which are subject to change.
This article does not constitute financial advice. Individuals must not rely on this information to make a financial or investment decision. Before making any decision, we recommend you consult your financial planner to take into account your particular investment objectives, financial situation and individual needs. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. This document may include forward-looking statements that are based upon our current opinions, expectations and projections.
