2016 sees major reforms to dividend taxation. Does it trigger a review of investment wrappers for existing savings?
There will be both winners and losers when the £5,000 annual dividend allowance is introduced in April. Higher rate taxpayers could be better off by up to £1,250 a year (£1,530 for additional rate taxpayers) but some basic rate taxpayer could be worse off by as much as £2,025.
Personal circumstances will ultimately determine the most appropriate investment solution for you. So in this article we look at:
- What’s changing?
- Who will be better off or worse off as a result of the changes?
- How the changes will impact on the main investment wrappers?
So what’s changing?
From 6 April 2016, the method for taxing dividends received by individuals will change. The 10% tax credit will disappear. Instead the first £5,000 of dividend income will be tax free for everyone. And the rates of tax are changing too for dividends exceeding this allowance.
What this means is that most basic rate taxpayers will be no worse off than this year, unless they have dividends in excess of £5,000. While £5,000 should be sufficient to cover the dividends from most basic rate taxpayers they will have to pay 7.5% on amounts over the allowance from next April.
The real winners are higher rate taxpayers and additional rate taxpayers with dividends of less than £5,000 each year. On dividends up to the allowance they would be £1,250 (HRT) and £1,530 (ART) better off each year.
But what about when the dividends received is greater than the allowance? There is tipping point where the tax savings on the first £5,000 are outweighed by the higher rates of tax imposed on dividends in excess of the allowance. That point arrives when dividends hit:
- £21,660 for higher rate taxpayers, and
- £25,400 for additional rate taxpayers.
Where dividends are below this figure you are still better off. Above this figure you will be paying more tax on your dividends than in previous years.
It is important to note that the full amount of dividend received, even if covered by the £5k allowance, will still count towards total income when determining income and capital gains tax rates, as well as entitlement to the personal allowance.
What does it mean?
The abolition of the 10% credit will not affect the of amount dividend that is distributed.
The tax credit was only ever a notional credit 10% tax is not deducted on distribution. The credit merely reflects the fact that the dividend was paid out of a company’s profits after corporation tax. So investors will receive exactly the same amount.
But how dividends are taxed will change. No tax credit means no more grossing up is required. The amount received is the amount subject to tax, with the first £5,000 of dividends tax free (note: if an investor has unused personal allowance, dividends would be used against this first – so these individuals could receive even more than £5,000 of dividends tax free).
Where to save now?
There are many nontax factors which will need to be considered. But putting these to one side and just focusing on the tax planning aspects it is the availability of reliefs and allowances which will generally determine the best place to save.
So, purely on the basis of tax, and all things equal (e.g. investment funds, charges), the order appropriate for most people would be:
The combination of tax relief on contributions, tax free investment returns and the ability to take a quarter of the fund tax free mean pensions will like for like outperform other wrappers. Only where the tax rate on withdrawing funds exceeds the rate of tax relief on contributions will it fall behind an ISA.
With tax free investment returns and unrestricted access ISA will remain the next best thing to a pension.
However, for many they may still be the vehicle of choice because of their simplicity, where funds may be needed before age 55, or where the you need an ’emergency’ fund.
But the tax advantaged status of pensions and ISA’s come with limits on how much can paid in. So for those with higher surplus income, or who have lump sums to invest (e.g. from inheritances or other maturing investments), where should they go next?
Equity unit trusts and OEICs v Offshore Bonds
The new dividend allowance makes a compelling argument for building up a collective portfolio where income and gains can be managed within the respective allowances. The result would be a ‘quasi’ ISA which has been built up without a tax drag, and importantly which could be accessed in the future without a tax charge.
Where fund values produce a dividend in excess of the allowance, and capital growth cannot be managed out annually using the annual CGT exemption, the choice becomes more difficult.
Offshore bonds can protect the excess dividends from an immediate tax charge as they arise, because they defer the tax charge until surrenders are taken. When this happens, bond holders are taxed at their highest marginal rates of income tax (20%, 40% or 45%) on the bond gain.
But if they can take their bond profits at a time when they are nontaxpayers, then they have an advantage over OEICs. OEICs will have suffered a tax drag on income during the investment period, and capital gains in excess of allowances on withdrawal could be hit with an 18% or 28% tax charge.
So to maximise the benefits of a bond, the trick is to extract at 0% tax, for example as a bridging pension by deferring taking benefits from pension plans, or assigning to non taxpayers such as grandchildren at university who can cash in to finance their studies.
The changes may trigger a review of your existing investments. But of course any future tax savings by changing investment wrappers must be balanced against any immediate tax charges as a result of disinvestment. And a phased strategy of disinvestment across a number of tax years may be considered to maximising the use of available allowances and reduce the tax payable.
If you would like to discuss how these changes might affect your investment decisions, please give us a call on 01825 76 33 66 or to book a free consultation complete the contact form.