The big dividend tax shake-up

Last week's Budget included several radical changes to our tax system and one of the biggest was the treatment of dividends. While George Osborne couched his plans in terms of an overdue reform of a "complex and archaic" system, the reality is that they will also lead to higher taxes for a number of investors and business owners.

It's certainly true that the way that dividends are taxed at the moment causes no end of confusion. Let's summarise the current rules. Dividends come with a 10% notional tax credit and carry notional tax rates of 10% for basic-rate taxpayers, 32.5% for higher-rate taxpayers and 37.5% for additional-rate taxpayers.

The tax credit offsets some of the notional tax due, meaning that basic-rate taxpayers usually pay no tax, higher-rate taxpayers pay 25% and additional-rate taxpayers pay 30.56% (although there are some quirks at the edge of tax bands because it's the value of the dividend plus the credit that determines which band you fall in).

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It is important to understand that this 10% tax credit is theoretical it's the legacy of old taxes that no longer apply. Even though your stockbroker sends you dividend vouchers that refer to "gross dividends" and "net dividends", this is done to reflect the way that the tax is calculated on your tax return. It does not mean that any tax has been deducted from your dividend. The reality is that the UK taxes dividends at rates of 0%, 25% and 30.56% we just use a very roundabout way of calculating that.

Clearly, getting rid of this needlessly complicated system is an excellent idea. Here's how the new rules will work. The 10% tax credit concept will be abolished. Instead, there will be an allowance that means your first £5,000 of dividends are tax-free. This applies whatever rate of tax you pay on the rest of your income. After that, basic-rate taxpayers will pay 7.5% tax on dividend income over £5,000 (other than anything covered by the personal allowance, which rises to £10,800 next year). Higher-rate taxpayers will pay 32.5% and additional-rate taxpayers will pay 38.1%.

Dividends paid into an individual savings account (Isa) or self-invested personal pension (Sipp) will be tax-free for all taxpayers, just as they are now. Again, don't be confused by the 10% tax credit. Many investors believe that their dividends are currently being taxed at 10% in Isas and Sipps because they can't "reclaim" the tax credit. But they aren't there is nothing to be reclaimed. So this doesn't mean that getting rid of the credit will increase the dividend you get in an Isa or Sipp you'll get exactly the same amount as you did before.

The majority of investors won't be affected by these new rules: to earn £5,000 per year in dividend income, you would need a portfolio of around £140,000. A few may even be better off (see box below). The obvious losers will be those with larger portfolios, who should consider trying to move holdings into Isas and Sipps.

But the real target of these changes are people who own their own companies and withdraw the profits as dividends rather than salary to take advantage of lower tax rates on dividends. This tax break will still exist, but will be reduced and it would not be surprising to see it shrink further in future Budgets.

How the new rules will work

The dividend tax changes that the chancellor announced are intended to come into effect in April 2016, although the proposals could be modified before then. Here are four examples of how the new rules could affect investors.

Jane earns £10,500 per year from a part-time job and receives £2,000 per year in dividend income from shares held in taxable accounts. Under the current rules she pays no income tax, because her salary is less than the personal allowance and there is no tax on dividends for non-taxpayers and basic-rate taxpayers. Under the new rules, she will continue to pay no tax. Her salary is still less than the personal allowance, while her extra dividend income is less than the dividend allowance.

Luther receives £25,000 per year from dividends, all from shares held in taxable accounts, and no other income. At the moment, he pays no income tax at all. From April 2016, £10,800 of his income will be covered by the personal allowance and£5,000 more by the dividend allowance, but the remaining £9,200 will now be taxed at the new 7.5% rate.

Rachael earns a salary of £60,000 per year, and receives £15,000 per year in dividends from shares held in taxable accounts. The new rules will have no impact on her salary, but will reduce the tax she pays on dividends. At present, all her dividend income is taxed at 25%; from April 2016, she will pay no tax on the first £5,000 and 32.5% on the remainder. As long as she has less than £21,667 in total dividends, this amounts to a net reduction (the equivalent point for an additional-rate taxpayer is £25,266).

Charles receives £90,000 per year in dividends from his own firm and other investments held in taxable accounts. He pays no tax on the first £38,146.5 (the £42,385 higher-rate band minus the 10% tax credit) and 25% on the remainder. Next year, he will receive £15,800 (£10,800+£5,000) tax-free, but pay 7.5% on the next £31,900 and 32.5% on the remainder.