The feasibility of drawing a comfortable income from the dividends paid on mid-sized share portfolios has reduced dramatically in recent years. In April 2016, the Government replaced dividend tax credits with a £5,000 dividend allowance, whereby the first £5,000 of dividend income was tax free. The change, while welcomed by those with the smallest portfolios, was detrimental for anyone relying on larger dividend incomes, including many retirees.
This year’s significant reduction in the dividend allowance, from £5,000 to £2,000 in April 2018, compounds the impact for income investors. For example, a pensioner on an income of £50,000, almost all derived from dividends and with the most basic state pension, is now paying considerably more tax than before 2010.
Less than ten years ago, an investor received a tax credit of 20% with their dividend income. This was reduced to 10% in 2010 and then abolished in 2016. Under the tax credit system, dividends were declared gross but paid to shareholders net, with investors receiving a tax voucher for 20% (and later 10%) of the gross value. Now that same income is received as a gross payment and taxed at the holder’s highest rate – 7.5% for basic rate taxpayers, and 32.5% and 38.1% for higher and additional rate taxpayers respectively.
For many, the changes to the taxation of dividend income are extremely detrimental. The absurdity of the new dividend tax treatment is that we now have a regime which favours capital profits at the expense of savings income. This impacts private investors across the age spectrum and could encourage a significant number to pursue growth strategies at the expense of income; the latter is commonly used to fund retirement.
Make a profit on an investment and, above a generous tax free amount of £11,700, you will pay just 10% (basic rate) or 20% (higher rate) of the gain in tax. Live carefully off what you have saved and invested during your working life and you will find that the ultra-low tax free dividend allowance doesn’t provide much shelter if you want to derive a meaningful income from your investments.
• £50,000 dividend income
• £48,000 of taxable income following use of £2,000 dividend allowance
• £3,600 of tax to pay at the basic rate, £15,600 at the higher rate and £18,288 at the additional rate
Equity income funds have been unfairly penalised by these changes and the penny is only beginning to drop. Anyone in receipt of dividends of more than £2,000 will receive a nasty shock from the tax man this year. In order to minimise his demands in future, there are many schemes available to turn income into capital, and to identify opportunities to turn income into capital growth, with the advantage of a lower tax rate.
But high yielding companies now have a bias against them. It is no accident that companies with low yields and modest but reliable real growth in earnings are now highly rated, but those with high yields are increasingly shunned by tax conscious investors. For those brave enough to invest in dividend stocks, careful consideration must be given to managing the tax liabilities. For many, tax efficient vehicles such as ISAs and pensions will be key – equity income strategies pay substantial dividends that investors won’t want to miss out on.
Angela Lascelles, Founder, OLIM Investment Managers