After a bruising 2020, dividend investors now face another curveball — this time from the Chancellor.
In his Budget, Rishi Sunak confirmed that the Treasury will hike taxes on dividends in April: with investors paying an extra 1.25 per cent from April.
The rise, which could see investors pay £3 billion more over five years, was part of Boris Johnson’s September plan to raise more money for the NHS.
Tax hikes: If an investor earns £10,000 from dividends next year, after factoring in their £2,000 allowance, their tax bill will rise by £100: 1.25% of £8,000
And while 1.25 per cent might not sound like much, experts say the move will hit older investors.
That’s because many pursue dividends (a style known as income investing) as a way of providing regular cash in retirement.
What’s more, the move will disproportionately affect investors paying the basic rate of income tax — i.e. the less well off.
As ever with taxes, the devil is in the detail and requires an understanding of how the current system works.
On top of their personal income allowance, all investors receive a £2,000 dividend allowance, with payments above that subject to tax.
Basic-rate taxpayers currently pay 7.5 per cent on dividend income, while higher and additional rate earners pay 32.5 per cent and 38.1 per cent. As of April, all these will rise, to 8.75 per cent, 33.75 per cent and 39.35 per cent respectively.
So if an investor earns £10,000 from dividends next year, after factoring in their £2,000 allowance their tax bill will rise by £100: 1.25 per cent of £8,000.
But for a basic-rate payer, who currently only pays £600 in tax on this income, it is a far more noticeable jump than for a higher-rate payer (whose tax will go up to £2,700 from £2,600).
The news comes as the FTSE 100 is set to pay out £84.1 billion in dividends this year, with initial signs pointing to a strong year in 2022. ‘UK dividends have generally recovered well from the pandemic,’ says Hargreaves Lansdown’s Nicholas Hyett.
‘The FTSE 100 currently offers a yield — the percentage of your investment paid back in dividends — of nearly 3.5 per cent.’
Steelmaker Evraz and miner Rio Tinto are set to lead the pack: with forecast yields of 17.9 per cent and 17.8 per cent respectively.
Of course, similar payouts aren’t guaranteed in 2022 and investors need to think carefully about how inflation might affect company profits.
Divi grab: In his budget, Rishi Sunak (pictured) confirmed that the Treasury will hike taxes on dividends in April: with investors paying an extra 1.25% from April
It’s why investors look carefully at the dividend cover: which shows how many times the company could pay out based on current profits.
‘Historically, income investors have also turned to defensive sectors, like consumer goods and pharmaceuticals when inflation rises,’ says Mr Hyett.
‘These companies enjoy strong brand power or are essential purposes, so they can pass on higher costs to customers.’
And how can investors minimise their tax bill?
For a start, any funds or shares held in a stocks and shares ISA are exempt from dividend tax, as well as capital gains tax.
It’s why any financial advisor worth their salt will tell you to always use your annual £20,000 ISA allowance — as once it’s gone, you can’t get it back.
For longer-term investors, though, it hasn’t always been so easy. Personal ISA allowances haven’t always been as generous as they are now. In fact, less than 15 years ago, they were only £7,200.
It means that many older investors will have built up nest eggs outside of their tax-free wrapper: which have likely grown over time.
‘Even if you’ve got a sizeable pot outside of your ISA, there are ways you can reduce your tax bill,’ says Laura Suter, a personal finance expert with investment platform AJ Bell.
The overall strategy, she says, is to sell some of your shares and then re-purchase them in an ISA (a move referred to as ‘bed and ISA’).
‘If you do this now, and then again in April when the new allowance begins, you could protect £40,000 before the new rate takes hold,’ she says. ‘If you’re a couple, you can effectively double your allowance: sheltering £80,000 from the taxman.’
Getting it right, though, may require some planning, particularly for those with larger portfolios.
If your shares have grown in value over the years, you need to think about capital gains tax.
Investors currently receive an annual allowance of £12,300: with any gains above that subject to tax at either 10 per cent or 20 per cent.
Remember, though, this only applies to your actual gain: not the overall value of your assets.
Buying and selling shares will also result in paying transaction fees (potentially around £9.95 per trade) to your investment platform.
As a result, Ms Suter recommends that, rather than moving across shares or funds at random, investors should prioritise those that pay the biggest dividends.
‘You should rank their assets from the highest-paying to the lowest — focusing on pounds and pence, rather than the percentage yield,’ she says.
Once the investments have been re-bedded in an ISA, all future gains and dividends are tax-free.
Meanwhile investors with spare cash — and ISA allowance — can take some of the risk out of dividend-hunting by looking at income-focused funds. Experts at AJ Bell, for example, have picked the Man GLG Income fund, which paid out 4.76 per cent in the past year.
The fund spreads investors’ capital across historically reliable dividend stocks — including Shell, Rio Tinto, Imperial Brands and Barclays.
By reinvesting their dividends, investors could have turned £10,000 into £14,400 in five years.
With many platforms offering lower (or free) dealing charges on funds, it may prove a cheaper way to grow your income.
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