Here is an example – if you own 40 shares in a company and that company pays you £10 per share in annual cash dividends, you will receive £400 per year. A dividend refers to the distribution of profits by a company to its shareholders.
You may receive a dividend if you have invested in shares. In addition, you may receive dividends if you have a family-run or owner-managed company and receive profits in the form of dividends. For tax purposes, dividends have their allowance and rates of tax.
Moreover, they can benefit from personal allowance if it is not used elsewhere. No tax is payable on dividends in a tax-free wrapper, such as shares ISA and stocks.
This blog post discusses the increase in dividend taxation rates applying for 2022/23 and what this means for those extracting profits as dividends and investors in general.
Dividends are the cherry on the cake
They are treated as the top slice of income. The tax rate of your dividends depends on what other taxable income you have in that year and whether you have already used up your dividend and personal allowance.
While personal allowance is the amount of income earned tax-free, dividend allowance is a zero-rate band and not an allowance wherein dividends are covered by the allowance being taxed at a zero rate.
But the thing is, the allowance utilizes only a part of the tax band in which it falls. All taxpayers are, therefore, entitled to a dividend allowance, irrespective of the rate at which they must pay tax. This is useful from a tax planning perspective in a family company situation.
It offers the opportunity to extract profits without triggering further tax liabilities. For 2022/2023, the dividend allowance is set at £2,000.
Dividend tax rates
There are three types of dividend tax rates you should know about:
- Dividend ordinary rate where dividends fall in the basic rate band
- The dividend upper rate applies to the extent that the dividend falls in the higher rate band
- Dividend additional rate, as the name suggests, is applicable when the dividends fall in the additional rate band
Dividends and National Insurance Contributions (NICs) do not go hand in hand. That means where profits in a family or personal company are extracted primarily in the guise of dividends; there would be no NICs to pay.
The dividend tax rates for 2022/23 are as follows:
- Ordinary rate: 8.75%
- Upper rate: 33.75%
- Additional rate: 39.35%
The ripple effect of the Health and Social Care Levy
From 6 April 2022, the government will introduce new tax-raising measures collectively known as the Health and Social Care Levy. The extra amount raised through the changes will act as ring-fenced funds for health and adult social care.
The changes will affect employers, the self-employed, employees, and individuals receiving dividends. The new tax measures comprise two elements – an increase in the income tax rates that apply to dividends and an increase in the rates of the NICs.
The income tax that you receive on dividends
Dividends are not subject to NIC and they are therefore not subject to the new levy. However, what has changed is the rate of income tax applicable to dividend income. The increase is applicable for all dividend income paid above the initial £2,000 nil rate band; the dividend income tax rates for trustees and individuals is increasing by 1.25%.
Wherever other tax rates are directly linked to those applying to the individual dividend tax rates – for instance, the 7.5% rate that applied to certain trustees – these will increase automatically.
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Different scenarios for paying dividends
HMRC is very clear that only those expenses directly related to your business can be claimed back, including salaries and wages, rent and electricity/water bills for office premises, purchase of goods for resale, accountancy fees and so on. You can also write off fixed costs (such as for fixtures or computer equipment) over eight years through capital allowances.
Example 1: No tax to pay
Alexa is a student and earns £4,000 in 2022/23 from her part-time job. Additionally, she holds shares in her father’s company, due to which she receives a dividend of £6,000. But because her total income for 2022/23 is less than her personal allowance of £12,570, she does not have to pay tax on her dividend income.
Example 2: Covered by allowances
Cassie receives a salary of £11,000. She also owns a small personal company, enabling her to pay herself a dividend of £4,000 for 2022/23. Her salary uses up £11,000 of her personal allowance for 2022/23 of £12,570, leaving only £1,570.
The dividend allowance of £2,000 covers this. That means Cassie does not have to pay any tax on the dividends as the amount is fully covered by her remaining personal allowance and the dividend allowance.
Example 3: Basic rate taxpayer
Nellie has a pension of £30,000 in 2022/23. She has a share portfolio from which she receives £16,000 worth of dividends in the same year. Nellie uses her personal allowance of £12,570 and the first £17,430 of the basic rate band, which is £37,700, leaving £20,270 in her hands.
The dividend allowance uses £2,000 of the basic rate band, leaving £18,270 available. The remaining dividends of £14,000 fall within the basic rate band and are taxed at the ordinary rate of 8.75% for 2022/23.
Example 4: Taxes at a dividend additional rate
Jenna receives an annual salary of £120,000 and has also received an income from a property of £60,000 in 2022/23. In addition to this, she has been paid dividends of £30,000 from her husband’s company and further dividends of £20,000 from her share portfolio.
The total dividend income received is £50,000, which falls in the additional rate band. As the first £2,000 of her dividend income is covered by the dividend allowance, the remaining amount of £48,000 is taxed at the dividend additional rate of 39.35%. In the end, she pays a tax of £18,888 on her 2022/23 dividends of £50,000. All other allowances are taken up by her salary and property income.
Extracting profits as dividends
For those with a personal or family company, paying profits as dividends is a tax efficient way to proceed. The lack of NICs on dividends, the lower rates on dividends and the availability of the separate dividend allowance maximizes the allowances available.
A common profit extraction policy is to withdraw a small salary equal to the personal allowance (£12,570) or the NICs primary threshold (£11,908 for 2022/23) – depending on whether the NI employment allowance is available and to extract further profits as dividends.
Dividends are paid out of retained profits, which have already deducted Corporation Tax at 19%. Moreover, a dividend can only be paid if the company has sufficient retained profits to withdraw the amount. Dividends must also be paid in proportion to shareholdings.
The limitation can be overcome by having an alphabet share structure which allows every shareholder to have their class of shares, i.e., A or B shares. That way, the dividends can be declared for different classes of shares.
This is helpful from a tax planning perspective, allowing profits to be extracted tax-free where shareholders’ personal and dividend allowance remain available.
Over to you
The influence of the increase in dividend tax rates applicable from 6 April 2022 can be confusing when calculating the tax you owe to the government or formulating profit extraction strategies. If you are not yet a Bradleys Accountants client, we can minimize all your tax worries with your dividend forms taken care of. Get all the support and guidance you need. Contact us today!