Interest and Dividends

We've already seen how income tax is payable on your salary or your pension income. 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. (Even though a person's income is in the 22% rate band, say from employment plus the interest itself, they are not liable to pay the additional 2%. HM Revenue & Customs lets you off that 2% - lovely people that they are!)

Let's say you have a job earning £30,000 per year, well within the basic tax band, and you're also earning interest from a building society account amounting to £1,000 before tax (£800 after the 20% has been deducted). Your total income will for tax purposes in the year be £31,000. Since this remains within the basic rate band, no further tax will be due, despite that fact that you are paying a marginal rate of 22% on the salary whilst the interest has suffered only 20% deduction at source.

But what if you have sufficient capital in the account to earn interest of £8,000 gross (£6,400 net)? Your total income is now £38,000. Hello, higher rate tax of 40% on part of the interest. Remember that in Part I we pointed out that you could earn a total of £37,295 before you switched to the upper tax bracket of 40% tax? Well, you've now earned £705 over that figure so you will have to pay 40% on that element of income i.e. an extra 20% on top of what has already been deducted by the building society. Note that the interest has to be treated as the top slice of income - HM Revenue & Customs will tax your salary first and then look at the income you may be getting from other sources.

The effect is that only a higher rate payer will have additional tax to pay on taxed interest.

At the other end of the spectrum, where you might be a non-taxpayer because your income is less than the personal allowance, you are allowed to reclaim the 20% tax that the building society has deducted. Alternatively, your bank can provide you with a special form, called an R85, that allows them to pay the interest to you gross.

Dividends

Dividends are even more complicated. They are not taxed at source like most interest, but carry a tax credit equivalent to 1/9 of the amount paid, or 10% of the grossed-up value. A tax credit is not the same as deduction at source because the paying company does not have to pay this credit over to HM Revenue & Customs.

The effect of this credit under the applicable rules is that no income tax is payable by any recipient of dividends whose total income is below the higher rate tax level, after adding in the grossed up value of those dividends. It is not a proper credit because, for example, a non taxpayer cannot recover it, unlike taxed interest where the tax deducted can be recovered in such circumstances.

Where the dividends are received by higher rate payers, then additional tax of 25% of the amount paid becomes payable, equivalent to 32.5% of the grossed up value minus the tax credit. Note that it is not 40%.