The reduction in the tax-free dividend allowance
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The expected reduction in the tax-free dividend allowance – should you be taking action now?
The £5,000 tax-free dividend allowance was introduced with effect from 6 April 2016 and dividend income received in excess of this allowance is taxed at 7.5%, 32.5% or 38.1% depending on the investor’s or shareholder’s marginal rate of income tax. But after only being in operation for a short period of time, Philp Hammond announced in the Spring Budget 2017 that this allowance is set to reduce by 60% to £2,000 from 6 April 2018. Due to the forthcoming election, the enactment of the relevant piece of legislation reducing the tax free dividend allowance has been postponed temporarily. However, this does still mean, from next year, investors and shareholders might suffer more tax on their dividend income, if this totals more than £2,000 in the tax year. So what should your clients be considering in advance of this proposed reduction?
1. Continuing to make use of the reduced dividend allowance
From 6 April 2018, an investor will still be able to earn £2,000 of dividend income tax free. If their investments yield on average 4% dividend income, this will mean that they can continue to hold investments to the value of around £50,000 and still benefit from this allowance. A word of caution though, remember that dividends from accumulation funds that are automatically reinvested also count towards this allowance, even though the investor doesn’t receive the cash.
Married couples and registered civil partners could consider transferring assets between themselves to make sure they’re in a position to use each spouse’s £2,000 tax free dividend allowance from next year. This could allow them to continue to hold investments with a value of around £100,000 if owned jointly or around £50,000 each, using an average yield assumption of around 4%.
2. Contributing to a Self-invested personal pension (SIPP)
A client could make use of their annual capital gains tax (CGT) exemption to make a contribution to a SIPP from their general investment account holdings both this tax year and at the beginning of the 2018/19 tax year. Dividends aren’t subject to income tax within the SIPP wrapper and growth on the underlying investments isn’t subject to CGT either. If they want to continue holding the same investments, they could consider a “bed and SIPP” arrangement to avoid any out of market exposure.
Subject to any annual and lifetime allowance restrictions, usually an individual will be able to make a contribution of up to £40,000 in the tax year (or more if they have unused allowance to carry forward). High earners subject to the tapered annual allowance or individuals who are subject to the money purchase annual allowance (proposed reduction to £4,000 from 2017/18) are more restricted with regards to the level of contributions they can make, that qualify for tax relief.
Where clients make personal contributions to a pension operating relief at source, they’ll be able to benefit from tax relief at basic rate at source and if they’re higher or additional rate tax payers they can claim the additional tax relief through their self-assessment tax return.
If a client is under 55 and needs access to their investment income and/or capital, then moving some or all of their assets from their general investment account to their pension might not be the right solution.
In contrast to owning investments directly in a general investment account, pensions can offer intergenerational planning and inheritance tax savings.
3. Using their ISA Allowances
Income received in a stocks and shares ISA isn’t subject to income tax and there isn’t any CGT payable on the capital gains. So clients could consider holding some of their higher yielding dividend producing investments within an ISA wrapper to take advantage of this beneficial tax treatment.
The ISA allowance for 2017/18 is £20,000. If this remains at £20,000 they could then invest another £20,000 at the beginning of the 2018/19 tax year. This would mean that a client could invest a total of £40,000 in a stocks and shares ISA over the next two years and protect the dividend income from being taxed at the more penal rate. If a married couple made use of both spouse’s ISA allowances this would mean that they could invest £40,000 each within stocks and shares ISAs.
Clients could consider using their annual CGT exemption of £11,300 this tax year and next year’s allowance too to contribute to their ISAs from their general investment account holdings. If they want to continue to hold the same investment(s), then they could consider doing a “bed and ISA” arrangement.
The tax treatment depends on the individual circumstances of each client and may be subject to change in future.
4. Other available options
Clients could consider investing in assets which attract only capital growth, as the CGT rates currently applying on the disposal of assets, other than residential property, are relatively low – 10% for basic rate taxpayers and 20% for higher and additional rate taxpayers. However, clients will need help to monitor the value of their investments going forwards and to actively make use of their annual CGT exemption each year to strip out gains to try to avoid the capital gains being subject to penal rates in the future, as the CGT rates are unlikely to stay this low forever.
Alternatively, clients could consider making using of their CGT annual exemption this tax year and next to release cash to invest in an offshore bond. UK dividends aren’t subject to income tax within an offshore bond wrapper and CGT doesn’t apply on switches of assets within the bond wrapper. The client can then make use of the 5% tax deferred allowance to take withdrawals from the bond. As an income tax liability generally only arises when a chargeable event gain occurs, a policyholder can try to manage their tax affairs so that this happens when they’re paying a lower marginal rate of income tax.
It’s worth remembering that trustees of a discretionary trust don’t benefit from the £5,000 tax free dividend allowance. The trustees have to certify on an R185 certificate that they’ve paid 45% tax when they make income distributions to a beneficiary. As dividends are taxed at 38.1%, the trustees have to pay additional tax if they distribute all the dividend income to beneficiaries. The trust distribution isn’t treated as dividend income in the hands of the beneficiary so the dividend tax free allowance isn’t available to for the beneficiary to offset either. Trustees of a discretionary trust will generally need advice to deal with the complexity of their tax affairs, if they invest in a general investment account.
6. Shareholders of limited companies
Shareholders of limited companies will need advice around their current and future remuneration strategy. They’ll be asking themselves if they should take dividends or salary and/or what level of employer contributions should the company make into their pension? Shareholders might want to consider taking more dividend this tax year rather than next to make use of the £5,000 allowance before it reduces to £2,000. Even with the reduced dividend tax free allowance, dividends are still going to be slightly more attractive than salary due to the national insurance savings they provide.
Shareholders should consider the fact that retaining too much cash within their limited company for a non-trade purpose could negatively impact on any business property relief that the shares attract and also on any entrepreneur’s relief that might be available when the shares are sold.
As the proposed reduction in the tax-free dividend allowance isn’t scheduled to come in until next year, clients should consider making use of this coming tax year and the start of the next tax year to take action to mitigate any additional tax that might arise as a result of this reduction. They’ll need advice in relation to mitigating any CGT exposure on rearranging their investments and using a platform with a CGT tool can help you in managing your client’s CGT position.
The value of any tax relief depends on your individual circumstances / the individual circumstances of the investor. This information is based on our understanding of current, taxation law and HMRC practice, which may change.