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The dividend allowance cut (and how you can beat it)

As a slow and steady strategy capable of turning even a modest amount of money into a small fortune over the long term, dividend investing takes some beating. Throw what you receive back into the market and let the power of compounding take over. Easy, right?

Yes, but there’s something you need to know.

Back in the 2017 Budget, it was announced that the dividend allowance — the amount investors could receive from assets held in their portfolios before being taxed — would be cut from £5,000 to £2,000 at the start of the new tax year.  

From April 6, 2018, any money received from investments above the £2,000 threshold will now be taxed at one of three rates. Basic rate taxpayers will be taxed 7.5% with higher rate taxpayers paying 32.5%. Additional rate payers will have any dividend income above £2,000 taxed at 38.1%. 

So, in the current tax year, someone receiving dividends of £5,000 would pay no tax. Under the new rules, the very same investor receiving the very same amount next year will be required to pay £225 if they pay the basic rate of tax (£3,000 x 0.075) and £975 if they pay the higher rate (£3,000 x 0.325). 

To make matters worse, there’s nothing to stop a further reduction in the dividend allowance being implemented further down the line, particularly as the £5,000 allowance has only been around for a couple of years.

Given the above, it’s not hard to see why this move has proved rather unpopular among retail investors. Here however, are some suggestions for how to limit its impact.

Grab an ISA

Thanks to their capacity to shelter any profits you make from capital gains tax, the importance of using as much of your £20,000 ISA allowance as possible can never be overstated. Another bonus is the fact that dividends come free of tax. It therefore makes complete sense to buy and hold as many of your investments as you can within this wrapper, especially shares in companies offering chunky dividend yields

Moving investments you already hold outside of an ISA into a tax-free account is also important. The process — called ‘Bed and ISA’ — involves instructing your broker to sell those holdings in your normal dealing account and re-purchase them within an ISA. The two transactions are carried out at the same time, thus limiting the impact of any market movements. You won’t be liable for any capital gains tax so long as you don’t exceed this year’s £11,300 allowance, although dealing costs and stamp duty will still apply.

If you have more than £20,000 in investments outside of an ISA, it’s worth transferring as much of the remainder as soon as possible in the new tax year and before any dividends have been paid, thus ensuring the latter aren’t taxed. Given that many growth-focused companies pay only small or no dividends, it’s also logical to give priority those stocks that generate the most income.

A final tip. Don’t forget that you can also use a spouse’s ISA allowance to protect your dividends, even if they have no interest in the stock market. Since married couples can transfer assets to each other free of capital gains tax, it’s therefore perfectly possible to protect up to £40,000 worth of investments before the new tax year arrives in a little under three weeks. 

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Paul Summers has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.