Dividend tax bills are rising: how to beat the hike

Tax year end is looming but there is still time to protect your investments from the taxman’s impending dividend tax raid. From 6 April the dividend tax-free allowances will be cut in half again, meaning investors could pay hundreds of pounds more in tax. But there’s still time to organise your investments to prevent the taxman from taking a chunk out of your returns before the deadline hits.

The crackdown on dividend tax has already led to higher tax bills for investors and company directors, but the move to cut the tax-free dividend allowance in half from £1,000 to £500 from 6 April will cast the tax net even wider. The cut will mean that from April an additional rate taxpayer who has more than £2,000 of dividends will pay £590 a year more in tax than they would have done this time last year, while a basic-rate taxpayer will face an extra £131 on their annual tax bill.

An estimated 1.8 million more people will be caught in the dividend tax net as a result of the cuts to the tax-free allowance, according to figures released by HMRC under a Freedom of Information request made by AJ Bell. Based on its estimates 635,000 more people will pay tax on dividends in the current tax year, as a result of the tax-free allowance being cut from £2,000 to £1,000 last April. But a further 1,115,000 additional individuals will be brought into paying dividend tax from April this year, when the allowance is cut again. On top of that, people who currently pay tax on their dividends will be facing a higher tax bill as a result of the cuts.

The FTSE 100 is forecast to yield 4.2% this year*, meaning an investor only needs £12,000 in their investment pot before they hit the tax-free limit. But that’s based on the average return, some FTSE 100 companies are forecast to deliver a dividend yield of 10% or more in the current year – meaning you only need to have £5,000 invested in them before you exhaust your tax-free allowance. Not only does this present a tax hit for individuals, but also an admin burden as they have to file a self-assessment tax return to declare the tax and subsequently pay the bill.

In anticipation of the coming tax raid, we’ve already seen a jump in the number of customers using ‘Bed & ISA’ transactions to utilise the more generous tax allowance this year and put assets in their ISA, out of the chancellor’s clutches.

How much more you’ll pay

Someone at the previous dividend allowance of £2,000 will be facing a bigger tax bill. Dividend tax is charged at 8.75% for basic-rate taxpayers, 33.75% for higher rate taxpayers and 39.35% for additional rate payers, following some previous tinkering from the government that simultaneously increased the tax rates and increased the number of decimal places they run to.

It means that a basic-rate taxpayer with £2,000 or more in dividends will pay an extra £44 a year in tax from April, on top of the additional £88 in tax they paid this year. Higher-rate taxpayers will owe £169 of extra tax from April, taking the total annual increase in their tax bill to £506 as a result of the cuts. Additional rate payers facing the highest rate of dividend tax will see their total tax bill increase by £590, with an extra £197 of tax due this year.

Paying this tax bill has a real impact on the effective yield your portfolio is generating. Take a £40,000 portfolio with 5% dividend yield – meaning it generates £2,000 of dividends. In the 2022-23 tax year all of this income would be tax free meaning your effective post-tax yield is still 5%. However, from next tax year that same investor has to factor in £506 of tax if they are a higher-rate taxpayer – meaning they only net £1,494 from their £40,000 portfolio – dragging the yield down to 3.73%.

*Source: AJ Bell Dividend Dashboard

How can I use an ISA to beat it?

All investments held in an ISA or pension aren’t subject to the dividend tax, so your route to a lower tax bill is to move your money into these accounts. Assuming you still want access to this money and don’t want it tied up in a pension, the best option would be an ISA.

The annual ISA allowance is currently £20,000, so you can potentially move £40,000 into your ISA before the tax hike starts to really bite by using this year’s allowance now and next year’s as soon as the new tax year starts in April.

If you have a spouse who also hasn’t used their ISA allowance this year (and doesn’t have their own investments outside an ISA) you can double this allowance and shift your portfolio away from tax more rapidly. These processes are called ‘Bed and ISA’ and ‘Bed and Spouse and ISA’.

A higher-rate taxpayer with £40,000 in non-ISA investments generating a 5% dividend yield would save themselves more than £5,000 in tax over the next 10 years if they transferred that money into an ISA in the next couple of months.

If your non-ISA investment pot is larger than your allowances the smartest move is to prioritise shifting your biggest dividend-paying investments into your ISA first. This means that you can shelter more of your dividend income from tax first and therefore cut your tax bill.

To do this you’d need to look at your portfolio and rank the holdings by how much income they generate. You then start at the top of this list and move the highest income generating investments into an ISA first, before working your way down. The exact amount of tax you’d save depends on your specific portfolio and how quickly those income-paying investments can be moved into an ISA.

More on Bed and ISA

More on ISAs