Interest and Dividends

Now let's look at the effect of investment income on the rates of tax. This is where the fun starts! Investment income is usually the interest you earn from your savings or the dividends you receive from holding shares.

Interest

Interest is usually taxed at source, the payer being mostly banks and building societies, deducting 20% then paying it over to HM Revenue & Customs. If you don't have much income, it is possible to get your interest paid gross by filling out a form known as an R85.

For more details, the Direct.gov.uk website has a useful guide.

Dividends

Cash dividends are charged to income tax at one of three rates, depending on the level of your other income. Dividends are always treated as the top slice of your income, and they could fall to be taxed in the basic (20%) rate, the higher (40%) rate or the additional (50%) rate band.

If dividend income falls into the basic rate band, investors are required to pay only 10% tax; in the higher rate band, 32.5%; and 42.5% where dividends are taxed at the additional rate.

Dividends also have a tax credit attached to them, which can be deducted when calculating any additional liability due. This credit is 10% of the gross value of the dividend (or 1/9 of the net amount received) and means that a basic rate taxpayer will have no additional tax to pay in respect of their dividends.

Higher rate and additional rate taxpayers will have an additional tax liability to account for, amounting to 22.5% or 32.5% of the gross dividend respectively.

Let's say you receive a cash dividend of £900. This is the net amount received.

The tax credit is £100 (£900 * 1/9) meaning that the gross value of the dividend is £1,000.

Here's how the additional tax liability can be worked out:

• Basic rate taxpayer = £1000 x 10% = £100 less tax credit = £0
• Higher rate taxpayer = £1000 x 32.5% = £325 less tax credit = £225
• Additional rate taxpayer = £1000 x 42.5% = £425 less tax credit = £325

Note that if you hold shares in an overseas company, the tax situation is a lot more complicated, as explained in this Fool article.