Understanding the Dividend Allowance: What It Is and How It Works
Please note: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only. You should always seek professional advice from an appropriately qualified adviser.
All contents are based on our understanding of current legislation, which is subject to change, any information provided here is only correct at the time of posting.
The Financial Conduct Authority do not regulate will writing, loans, credit cards or some forms of mortgage, tax advice, offshore investments and estate planning.
There is a risk to your capital and you may not get back the full amount invested. The value of investments, as well as the income from them, can fall as well as rise.
If you hold investments that generate dividend income, understanding the dividend allowance is crucial. Introduced to simplify the tax system and encourage investment, the dividend allowance determines how much tax-free dividend income you can receive each tax year. However, with recent changes to tax allowances and increasing rates, it is more important than ever to grasp the implications of dividends on your overall tax liability.
This blog post will explain what the dividend allowance is, the type of income subject to dividend tax, the applicable rates, and strategies to minimise your tax burden using tax-efficient wrappers like ISAs and pensions.
What Is the Dividend Allowance?
The dividend allowance is the amount of dividend income an individual can receive each tax year without paying tax. As of the 2024/25 tax year, the dividend allowance is £500.00 per year (for the 2024/25 tax-year). Any dividend income above this threshold will be subject to dividend tax, which is charged at rates depending on your income tax band.
What Type of Income May Be Subject to Dividend Tax?
Dividend income typically arises from investments in shares, whether through direct ownership of company shares or equity-based funds. If you own shares in a business, whether it’s a publicly listed company or a private one, any dividend paid to you forms part of your dividend income. Dividends are also common for company directors who own shares in their own limited companies.
The tax rates on dividend income vary depending on your total taxable income:
• Basic Rate Taxpayers: 8.75% on dividend income above the allowance
• Higher Rate Taxpayers: 33.75% on dividend income above the allowance
• Additional Rate Taxpayers: 39.35% on dividend income above the allowance
Examples of How Dividend Tax Works
Let’s look at two examples to illustrate how dividend tax applies to basic-rate and higher-rate taxpayers.
Example 1: Basic-Rate Taxpayer
John earns £30,000.00 from his salary and receives £3,000.00 in dividend income from his investments in shares.
• John’s total income is £33,000.00, keeping him in the basic tax band
• The first £500.00 of dividend income is covered by the dividend allowance and is tax-free
• The remaining £2,500.00 of dividend income is taxed at 8.75%
Tax Calculation:
• Taxable dividend income: £2,500.00
• Tax owed: £2,500.00 x 8.75% = £218.75
Example 2: Higher-Rate Taxpayer
Sarah earns £60,000.00 from her salary and receives £5,000.00 in dividend income from her shares in a private company.
• Sarah’s total income is £65,000.00, placing her in the higher tax band
• The first £500.00 of dividend income is tax-free
• The remaining £4,500.00 is taxed at 33.75%
Tax Calculation:
• Taxable dividend income: £4,500.00
• Tax owed: £4,500.00 x 33.75% = £1,518.75
How to Pay Dividend Tax
Dividend tax is not automatically deducted, so it is your responsibility to report and pay the tax to HMRC. Typically, you would use the following methods:
1. Self-Assessment Tax Return:
If your dividend income exceeds the £1,000.00 allowance, you will need to register for self-assessment and declare the income on your annual tax return.
2. Tax Code Adjustment:
HMRC may adjust your tax code so the dividend tax is collected via your salary or pension payments.
3. Lump-Sum Payment:
Alternatively, you can make a lump-sum payment to HMRC for any outstanding dividend tax by the payment deadline.
Tax-Efficient Wrappers to Reduce Dividend Tax
Investing through tax-efficient wrappers such as ISAs and pensions can help reduce or eliminate dividend tax altogether. Here’s how these options work:
1. Individual Savings Accounts (ISAs):
Dividends earned within ISAs are entirely tax-free. The annual ISA allowance for the 2024/25 tax year is £20,000.00, allowing you to shelter a significant amount of investment income from dividend tax.
2. Pensions:
Dividend income earned within pension funds is also tax-free. By contributing to a pension, not only do you receive tax relief on contributions, but any growth or income generated within the pension remains free from tax while inside the wrapper.
3. Other Tax-Efficient Investments:
For example, Venture Capital Trusts (VCTs) and Enterprise Investment Schemes (EISs) often come with dividend tax relief and other tax benefits. However, these are higher-risk investments, so professional advice is essential.
Why Is It Important to Plan Ahead?
Failing to manage your dividend income effectively could result in unnecessary tax liabilities. For example, if you exceed the dividend allowance and have an available ISA allowance, you could pay dividend tax unnecessarily. Tax planning can help ensure your investments are aligned with your overall financial goals while minimising your tax exposure.
Seek Financial Advice
While understanding the dividend allowance and tax-efficient wrappers is important, the rules and thresholds are complex and subject to change. Additionally, your financial circumstances, investment goals, and tax position are unique, so a one-size-fits-all approach will rarely suffice.
A qualified financial adviser can help you:
• Assess your current dividend income and tax position.
• Make the most of tax-efficient wrappers like ISAs and pensions.
• Develop a tailored investment strategy that aligns with your financial goals and minimises tax liabilities.
Conclusion
The dividend allowance provides a valuable opportunity to earn tax-free income from your investments. However, for individuals with substantial dividend income, understanding the rates, rules, and available strategies is essential. Whether it’s by making the most of ISAs and pensions or carefully managing your taxable income, planning ahead can help you maximise your returns.
By seeking professional financial advice, you can ensure that your investment strategy is not only tax-efficient but also aligned with your personal financial goals. Don’t let unnecessary tax liabilities erode your wealth—plan today for a better tomorrow.