How income tax is charged on dividends
Investors can put their money into all sorts of income-generating assets, the most obvious ones being shares for dividends, property for rents, and bonds and cash for interest.
Each has benefits and drawbacks. There is no risk investing in Government bonds and very little risk investing in bank deposits. However, as shown in the previous chapter, these investments offer little or no protection against inflation.
Property rents should rise over time but your income could suffer if the property is empty for a protracted period or if you incur unexpectedly high costs associated with the property.
Share dividends also offer protection against inflation but dividends can be cut or fall away completely if the company experiences financial hardship or goes bust. This risk can, however, be reduced by investing in an income unit trust or other income-focused investment fund.
One of the prime considerations for income investors is how big the yield is on different types of assets. By yield we simply mean income expressed as a percentage of the amount invested. A £100 asset that pays £10 has a 10% yield. Care has to be exercised when comparing yields on different investments because of factors such as tax, hidden costs and inflation protection.
Many investors are lured by high initial yields. For example, a corporate bond yielding 5% appears a lot more attractive than a share paying 3%. However, some assets, in particular shares, generally offer low initial yields but the prospect of a steadily rising income to protect you against inflation. Bank deposits and bonds, with the exception of index-linked gilts, offer no such protection and you're likely to see the real value of your income erode over time. Caution also has to be exercised when comparing income yields on different types of investment as there is often a wide divergence between gross income yields and net income yields. By 'gross' we mean income before deducting all costs and tax.
For example, if you buy a property with a rental yield of 8% there's a good chance that well over half of this will be eaten up by tax and other costs... even if you buy the property outright without using borrowed money. From the property's rental income you have to deduct maintenance costs and wear and tear, insurance and letting agent's fees and it's not uncommon for property to lie vacant for one month out of every 12.
With shares there are no hidden costs to worry about -- what you see is what you get! So a dividend yield of 8% from shares is far more attractive than a rental yield of 8%.
Furthermore, dividends are taxed much more favourably than most other types of income. In 2011/2012 higher-rate taxpayers only have to pay 25% tax on their dividends, compared with 40% on their rental profits and 40% on their interest income. So even if your property and shares pay you the same income, the taxman will let you keep 15% more of your share income. If your income is above £150,000 you'll be subject to the new 36.1% additional tax rate on dividend income, compared with the 50% payable on rental income or interest income.
And if you're a basic-rate taxpayer you don't have to pay any tax on your dividends, whereas you have to pay 20% tax on your rental profits and interest income. A married couple, who earn no other income, can therefore each receive gross dividends of almost £42,500 without paying a penny in income tax!
Another important difference between dividends and property rents is that for higher-rate taxpayers dividends can be converted into completely tax-free income by investing through an ISA. (Basic-rate taxpayers receive no tax benefits from ISA dividends.)
The tax treatment of dividends can be extremely confusing because of terms like 'tax credit', 'net dividend' and 'gross dividend'. In reality it's quite simple when you cut through all the jargon. In this article we will explain in plain English how dividends are taxed. Then we'll look at some useful tax-planning strategies.
Definitions
Net Dividend
This is the most important dividend number because it is the actual payment you receive from the company whose shares you own. In other words, the cheque you receive is the net dividend. If you are a higher-rate taxpayer (see Appendix A) you will then have to pay income tax of 25% on this amount (36.1% if you are subject to the additional rate).
Gross Dividend
This is calculated by 'grossing up your net dividend'. To do this you multiply the net dividend by 10/9. For example, if your net dividend is £100, the gross dividend is:
£100 x 100/90 = £111.11
This amount is then used when calculating your annual tax bill, as will be shown below.
Tax Credit
When you receive your dividend cheque (your net dividend) it will also detail an amount of 'tax credit'. This is simply 10% of your gross dividend. So if the net dividend is £100 and the gross dividend is £111.11, the dividend tax credit is:
£111.11 x 10% = £11.11
It is important to note that the tax credit cannot be used to create an income tax refund.
Are Gross Dividends and Tax Credits Important?
It's the net dividend that is the most important number for your financial planning because this is the actual income you receive. Gross dividends and tax credits are only important when it comes to doing your paperwork and filling in your tax return.
The Dividend Tax Calculation
Although the 'effective' tax rate for dividends is 36.1% for anyone with income above £150,000, 25% for higher-rate taxpayers and 0% for other taxpayers, the 'formal' tax rates are 42.5%, 32.5% and 10% respectively. How you arrive at 36.1%, 25% and 0% is by deducting the tax credit when you do your tax calculation. This is best illustrated by means of some examples.
As we've said, when an individual receives a dividend, the amount received is 'grossed up' by the fraction 10/9 and this is known as the gross dividend. The gross dividend is taxed along with the taxpayer's other income.
Example 1 -- Basic-rate taxpayer
John receives a £90 dividend. His tax calculation is as follows:
Gross Dividend: £90 x 10/9 = £100
Tax @ 10% = £10
Tax credit: £100 x 10% = £10
Tax payable = £0
Example 2 -- Higher-rate taxpayer
Jack a higher-rate taxpayer receives a dividend of £90. His tax calculation is as follows:
Gross Dividend: £90 x 10/9 = £100
Tax @ 32.5% = £32.50
Tax credit: £100 x 10% = £10
Tax payable = £22.5
Jack has actually received £90. Out of this he will have to pay £22.50 to Revenue and Customs. The effective tax rate is therefore 22.5/90 = 25%.
Example 3 -- Additional-rate taxpayer
Denis has income above £150,000 for 2011/2012 and is therefore subject to the new additional rate of tax. He receives a dividend of £90. His tax calculation is as follows:
Gross Dividend: £90 x 10/9 = £100
Tax @ 42.5% = £42.50
Tax credit: £100 x 10% = £10
Tax payable = £32.50
Denis has actually received £90. Out of this he will have to pay £32.50 to Revenue and Customs. The effective tax rate is therefore 36.1% (£32.50/£90).
If your dividend income pushes you into the higher-rate tax bracket, your effective tax rate on your dividend income will lie somewhere between 0% and 25%. To see why, it's first important to have a firm grasp of UK income tax rates.
UK Income Tax Rates
For the 2012/2013 tax year the following tax rates apply: £ • Savings rate -- 10% = 2,710
• Basic rate -- 20% = 34,370
• Higher rate -- 40% = Up to 150,000
• Additional rate -- 50% = Over £150,000
The special savings rate that applies from 6 April 2008 applies only for the purposes of savings income (essentially interest). However, if you have any non savings income (e.g. salary, profits or rents) above the £2,710 savings band, the 10% savings rate would not be available. The interest would then be taxed at the 20% basic rate.
In addition, everyone enjoys a personal allowance of £8,105, which means the first £8,105 of income you receive is completely tax free. What this means is that you only pay tax at 40% when you earn more than £42,475 (£34,370 + £8,105).
It's also important to point out that dividends are the 'top slice' of income so if you earn salary or other income such as rents and interest of more than £42,475, all of your dividends will be taxed at the higher rate. Now let's see how much tax an investor pays who earns all his income from dividends.
Example 1
Phil receives dividends of £45,000 and no other income. How is his tax calculated? £ Gross Dividends £45,000 x 100/90 = 50,000
Less: Personal allowance = 8,105
Taxable income = 41,895
Tax @ 10% on first £34,370 = 3,437
Tax @ 32.5% on balance £7,525 = 2,446
Total Tax = 5,883
Less Tax Credit (10% taxable dividend) = 4,189
Tax payable = 1,694
In total Phil earns £45,000 in dividends and pays tax of £1,694 -- an effective tax rate of just 4%. The tax credit is reduced from £5,000 to £4,189 as part of the dividend is offset by the personal allowance. This restriction usually only applies if there is no other taxable income arising in the year.
This example illustrates that dividends are an extremely tax efficient form of income.
Payments on Account
Most taxpayers only have to pay income tax on their dividends when they submit their annual tax return. For tax year 2012/2013 if you're filing online you need to file by January 31 following the end of the tax year (31 January 2014 for tax year 2012/2013). If you're filing a paper return you will need to submit it by 31 October 2013 (for the 2012/2013 tax year).
However, if you earn a lot of income from dividends you may have to make two 'payments on account'. These are based on your income tax liability from the previous tax year and have to be paid by 31 January during the tax year and by 31 July following the tax year.
Payments on account are not necessary if:
• Your tax liability for the previous year (net of tax deducted at source) is less than £500, or
• More than 80% of your previous year's tax liability was met by tax deducted at source.
If you have substantial dividend income, or are a share trader, these provisions may therefore apply to you.
Note that interest, which is usually subject to deduction of tax at source, would not be included in assessing whether payments on account are due.
About the Author
The Author of this article is our site Editor, Lee Hadnum. Lee is a rarity among tax advisers having both legal and chartered accountant qualifications. After qualifying a prize winner in the Institute of Chartered Accountants exams, he also went on to become a chartered tax adviser (CTA).
He worked in Ernst & Youngs Entrepreneurial Services department for a number of years before setting up his own tax planning practice. He is now a full time tax author.
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