The Budget was short on headlines but chancellor Philip Hammond’s dividend tax plans, reducing the amount that can be enjoyed tax-free, was one announcement?that did cause a minor uproar.
There was a lot of controversy after the Budget about how hard-working business owners have been targeted by the chancellor’s decision to reduce the tax-free dividend allowance from £5,000 to £2,000. Some commentators even likened the reduction, planned for April 2018, to a “Trojan Horse .
Of course, this dividend tax increase is unwelcome but it is not a major issue for most business owners and, with proper planning, it will often be possible to mitigate the impact. In many ways, it is an example of the ?noise that surrounds Budgets but that should not be allowed to distract business owners from their long-term personal financial planning goals.
We are, though, aware that it is an issue which has, rightly or wrongly, caused some concern so this article explains what is happening and what can be done about it.
What is changing with the dividend tax hike
Dividends are taxed at rates that are lower than those that apply to earned income. Since April 2016 individuals have, in addition to the standard income tax personal allowance, received an extra allowance that allows them to receive up to £5,000 in dividend income tax-free.
The forthcoming reduction of the dividend allowance from £5,000 to £2,000 will, all things being equal, represent a tax increase of £225 for basic rate taxpayers, ?975 for higher rate taxpayers, and £1,143 for additional rate taxpayers. It could also push some people into higher tax brackets.
But, all things are unlikely to be equal by 6 April 2018. The government made a manifesto commitment to increase both the standard income tax personal allowance and the higher-rate threshold very substantially by 2020. Assuming these increases are implemented as promised, they are likely to be phased in over the next few years and will mean that nobody is actually likely to feel poorer as a result of the dividend allowance cut.
Nobody’s long-term financial plan should, therefore, be substantially affected by this change.
Drawing an income by way of dividends will usually remain a more tax-efficient route for business owners to extract cash from their companies than taking the equivalent salary. Although corporation tax is also deducted from the profits used to pay dividends, this will still amount to less than the income tax and employee and employer National Insurance contributions (NICs) payable on a salary.
This tax differential between salary and dividends, although still appreciable, will of course be eroded somewhat by the dividend allowance cut. Some individuals may, therefore, wish to look at ways of mitigating this reduction.
One of the most obvious ways to do this would be to reduce the level of dividend and, instead, for the company to make a larger pension contribution on behalf of the owner, assuming the various allowances that apply to pension funds provide sufficient leeway. There would be no tax payable on the contribution, any investment growth would be sheltered from tax, and 25 per cent of any sums eventually withdrawn from the pension scheme will also be free of tax.
Another, very straightforward, option to consider is spreading shareholdings between spouses, thus benefiting from two dividend allowances (so £4,000 rather than £2,000 before tax becomes payable). This is more beneficial still if the spouse is a non-taxpayer or basic-rate taxpayer. It can also open up the possibility of two sets of Entrepreneurs” Relief when the business is sold.
What about investors?
The dividend tax rise will affect investors with larger investment portfolios that are held outside ISAs and pensions. With proper advice, these investors may be able to realise a portion of these investments each year and reinvest the proceeds in ISAs, which enjoy tax-privileged growth.
If ISA allowances are fully utilised then other tax-efficient (though not tax-free) options, including insurance company bonds, do exist. These can be complex, with a number of pitfalls, so good financial planning advice is essential.
Comprehensive dividend tax planning
The dividend allowance cut may not in itself be particularly important but the strategies outlined above demonstrate the power of proper financial planning. When applied to a family’s entire stock of assets, and carried out in pursuit of a long-term financial plan, the employment of legitimate tax reliefs can have a transformative effect, enabling individuals to enjoy their wealth to the full.
Jonnie Whittle is a financial planner at specialist wealth management firm Clarion Wealth Planning.