In September 2021, the UK government announced that dividend tax rates would rise by 1.25% from April 2022. The money raised will be used to fund the cost of social care and the NHS.
Given that the dividend tax rate is determined by income tax bands, how will the tax hike affect people in different income brackets? More importantly, how can you minimise the impact of the hike on your income or even avoid paying it altogether?
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How are dividends taxed?
Dividends are typically taxed based on your income tax rate.
All taxpayers get an annual tax-free dividend allowance of £2,000 on top of the £12,570 standard Personal Allowance. Any amount above the £2,000 threshold is typically subject to tax.
Under the new rates, basic rate taxpayers will now pay 8.75% tax on dividends, up from 7.5%. Higher rate taxpayers will pay 33.75%, up from 32.5%, while top rate taxpayers will pay 39.35% up from 38.1%.
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How will the hike affect people in different income brackets?
While dividend tax rates vary depending on your income, the dividend tax bill for all earners is set to rise by the same amount.
As an example, investors who earn £22,000 in dividends outside of a tax wrapper will pay £250 more under the new tax rate, whether their annual income is £20,000 or £200,000.
According to Sarah Coles, senior personal finance analyst at Hargreaves Lansdown, this means that people on low incomes and who might therefore be more reliant on investment income will feel the pinch more acutely.
An example, as highlighted by Coles, is retirees who might currently be living on a modest retirement income after doing the right thing in their working life by investing for their future.
How can you protect your dividends from tax?
Luckily for investors, there is a way to minimise the impact of the dividend tax hike on their income. It’s even possible to avoid paying dividend tax altogether.
They can do so by capitalising on the tax advantages of an ISA, more specifically, a stocks and shares ISA.
A stocks and shares ISA is basically a tax wrapper that you can use to shield your investments from tax. Any returns from investments held within a stocks and shares ISA are exempt from capital gains tax as well as dividend tax.
Right now, you can invest up to £20,000 a year in a stocks and shares ISA.
Worth noting is that it’s possible to transfer assets between married couples without triggering a tax bill. That means you can cut your dividend tax bill even further by spreading your taxable portfolio between you and your spouse, thus taking advantage of both of your ISA allowances.
So, in the next few months, as highlighted by Coles, a couple can shelter as much as £80,000 of investments from tax (£40,000 right now and £40,000 after the new tax year in April).
If you have children, you can spread your investments even further and thus cut your dividend tax even more by opening a junior ISA for them. The maximum amount that can be invested in a junior ISA per year is £9,000.
What if you can’t fit everything into an ISA?
If you have a relatively large portfolio, you may not be able to fit everything into an ISA. That means that some of your investments could still be exposed to dividend tax.
If you find yourself in this situation, Coles suggests that you prioritise protecting the investments that generate the highest dividends.
That could mean leaving growth-oriented investments outside ISAs. Though these investments will be subject to capital gains tax, this can be deferred and managed through your other annual allowances.
Ready to protect your investments from the looming dividend tax hike by switching them to a stocks and shares ISA? Take a look at our list of top-rated stocks and shares ISAs to see if you can find one that is a good fit for you.
Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, nor does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.
