Over recent years there have been changes in how income from savings and dividends are taxed. This is a brief summary.
Bank/Building Society Interest – 2017/18 onward – (called Savings Income)
- Tax is no longer deducted at source by Banks / Building Societies (from April 2017)
- There is a 0% Starting Rate band for Savings Income of £5,000
- There is a Personal Savings Allowance (16/17 onward) of
- £1,000 for Basic Rate taxpayers
- £500 for Higher Rate taxpayers
- £0 for Additional Rate taxpayers
Note – dividends are not Savings Income for these purposes – Dividends are covered below.
How do these work in practice?
Well, the Starting Rate allows for an exemption up to starting rate plus your Personal Allowance (2021/22 £12,570) – it tapers off to the extent your other income (wages, pension, business profit) exceeds your Personal Allowance. This is easier to explain by example:
- If your other income exceeds £17,570 you get no Starting Rate (£12,570 + £5,000)
- If your other income is less that £12,570 your Starting Rate is £5,000
- If your other income is between £17,570 and £12,570, your Starting Rate is £5,000 less £1 for each £1 that your other income exceeds £12,570
See HMRCs fact sheet on Savings Income
The Personal Savings Allowance comes on top of these amounts – see HMRCs fact sheet on Personal Savings Allowance
In practice this means:
- You disregard the first £1,000 or £500 of interest (the Personal Savings Allowance); then
- You apply the Starting Rate banding above
In theory for 2020/21 you could have £18.500 of tax free income, being £12,500 Personal Allowance, £5,000 0% Starting Rate and £1,000 Personal Savings Allowance, but this is only going to apply to someone with Savings Income – interest – of more than £6,000, and other income such as pension or wages, of less than £12,500 – somewhat hypothetical.
This is an absurdly complex regime for people on low income, and represents political meddling of the highest order! For pensioners, the low income and those living off savings, the regime is relevant, but if your income from wages/rent/business profit/dividend exceeds £17,500 (2020/21) – which applies to most people – it will not be relevant.
Although dividend income is investment income, in tax speak its not Savings Income, and the regime outlined above for savings income doesn’t apply.
Rules for dividends changed from 2016/17 onwards:
- Dividends no longer carry a tax credit or are subject to grossing up.
- There is a £2,000 Dividend Allowance (which was £5,000 in 2016/17 and 2017/18) – note the Dividend Allowance is part of the regular Basic Rate and Higher Rate bands, and not separate – it is a nil rate on that slice of dividend within the regular tax band
- Dividends over £2,000 are taxed as follows:
- Basic Rate 7.5%
- Higher Rate 32.5%
- Additional Rate 38.1%
How does this effect things?
- Dividend £10,000 net received by a Basic Rate taxpayer . No longer grossed up. £2,000 of the dividend is covered by the Dividend Allowance, the balance of £8,000 is taxed at 7.5% = £600.
- Dividend £10,000 net received by a Higher Rate taxpayer. No longer grossed up. £2,000 of the dividend is covered by the Dividend Allowance, the balance of £8,000 is taxed at 32.5% = £2,600.
Impact of the 2016/17 changes to Dividends
The old rules, applying up to and including 2015/16 were:
- Dividends count as the highest slice of your income
- Dividends have a 10% tax credit attached to them – this is non refundable so can’t be used to generate a tax repayment.
- There are special tax bands for dividends which treat the 10% tax credit as if it were 20% – the logic behind this is that Small Company Corporation Tax is kept at a level similar to Basic Rate Income Tax, so dividends, being distributions of profit, have already been taxed.
- The dividend ordinary rate is 10%, applicable to dividend income in the Basic Rate tax band – this matches the 10% tax credit
- The dividend upper rate is 32.5%, applicable to dividend income in the Higher Rate tax band
- The dividend additional rate is 37.5%, applicable to dividend income in the Additional Rate tax band
To explain the logic a little:
- Net dividend of £10,000 received by a Basic Rate tax payer. This is treated as a gross dividend of £11,111 and tax deducted at source of £1,111 (tax credit). By virtue of the 10% dividend ordinary rate there is no further tax to pay, as the tax due of £11,111 @10% is covered by the tax credit.
- Net dividend of £10,000 received by a Higher Rate taxpayer. This is treated as a gross dividend of £11,111 and tax deducted at source of £1,111. Tax due is £11,111 x 32.5% = £3,611 less £1,111 tax credit equates to a further liability of £2,500 payable via Self Assessment.
- If the £10,000 net dividend in eg 2 carried a credit of 20%, equating to the Corporation Tax paid at by the company on the profit before dividends then the grossed up amount would have been £12,500 and tax at 40% £5,000 with £2,500 paid at source and a further £2,500 due under Self Assessment. This explains how the 32.5% rate (and with the same logic the 37.5%) rates work. As to why, well its to do with a rate on pension schemes in one of Gordon Brown’s early budgets late 1990s.
Be aware that the old and new tax rates on dividends are not directly comparable, as the old ones, 2015/16 and earlier, were on a grossed up dividend, the new 2016/17 onwards regime has no grossing up. Bearing this in mind:
|15/16 effective tax||16/17 onward effective tax|
This table shows the marginal tax on the dividend (assuming the Dividend Allowance is already used) and the Corporation Tax. Due to there being no grossing up in the post 16/17 regime the 7.5% additional tax translates to a 6% effective increase.
One further thing to note for 2016/17 onwards – the Dividend Allowance is a 0% band not an exemption, so the dividends covered by the £2,000 Dividend Allowance still count as income for determining what tax band you are in – for someone with other income at the top of a tax band this may be enough to push them into the next tax bracket, relevant for the taxable element of the dividend or for CGT which is separately taxed as notional top slice of income.
We did some analysis on the change to dividend taxation for 16/17 at the time of the 2015 Summer Budget being published; although there was some uncertainty at the time, the detail worked out broadly as we interpreted/predicted at the time. These may be of interest: