Wealthy pensioners and investors to be hit by new dividend taxes

In the first budget of the new government, Chancellor George Osborne announced changes to the way that investors will have their dividend income taxed that could significantly impact wealthy pensioners and investors.

Under the current dividend tax system, basic rate taxpayers pay no tax on the dividends they receive outside their ISA or pension; higher rate taxpayers pay 25%, and additional rate taxpayers pay 30.56%. This is enforced through the dividend tax credit system via investors' annual tax returns. Dividends paid inside ISAs and pensions do not incur tax.

However from April 2016, the chancellor says that the dividend tax credit system will be replaced by a new £5,000 annual tax-free dividend income allowance for all taxpayers.

Winners and losers

Those whose dividend income exceeds £5,000 will pay tax according to their marginal income tax band: 7.5% for basic rate taxpayers, 32.5% for higher rate taxpayers and 38.1% for additional rate taxpayers.

The main beneficiaries of the new rules will be higher and additional rate taxpayers whose dividend income remains below £5,000, who will now pay no tax at all on their dividend income - a potential saving of £1,250 per year.

In contrast, basic rate taxpayers whose dividend income exceeds £5,000 and those investors with portfolios in excess of 140,000 will potentially pay significantly more under the new regime.

In the basic rate bracket, investors will now have to pay 7.5% on all income above the threshold, where under the current rules they can theoretically earn up to £42,385 in dividend income tax-free (if they are not receiving income from any other source).

This means that wealthy pensioners who rely largely or solely on dividend income to fund their retirement could see their tax bills rise significantly under the new rules.

For example, a retiree who currently receives the basic state pension of £115.95 per week (£6,029.40 per year) plus £36,355.60 in dividend income pays no tax on their income, as the state pension falls within the £10,600 personal allowance and the dividends attract no tax.

However, under the new regime the same retiree could potentially pay more than £6,690 in income tax on the same income.

Those with large portfolios - according to the chancellor, those worth more than £140,000 - also stand to lose out, as the benefits of the new dividend personal allowance are overridden by significantly higher tax on their additional dividends above the £5,000 threshold.

The rules will also significantly impact sole traders who choose to pay themselves an income in the form of dividends from their own companies - a strategy that the new rules have been designed to curb.

Speaking to Money Observer, Chas Roy-Chowdhury, head of taxation at ACCA, says: "The Treasury will be gaining largely from people with lots of stocks and shares, with closed company holdings, and one-man bands paying themselves entirely in dividends.

"However, for people who have retired early, so don't get state pension yet, and who rely on their investments, it's not unrealistic that they could be paying tax where they wouldn't have done before. Those people could be hit," he says.

Roy-Chowdhury advises those investors who may be affected by the new rules to begin planning and making arrangements now.

He says investors can take a number of measures. These include transferring capital assets between spouses or civil partners to spread investments across individual allowances and income tax bands, and divesting out of shares and into ISAs; those paying themselves through dividends will need to assess whether it is still cost-effective to do so.

Danny Cox, head of financial planning at Hargreaves Lansdown also suggests investors with SIPPs make the most of their savings allowances (as dividends paid into pensions are tax-free) and shelter their higher-yielding investments in ISAs.

For more sophisticated investors, Cox also suggests considering Venture Capital Trusts (VCTs) - where dividends are entirely tax-free.