Whilst the recent Budget may have been relatively boring, the reduction in the amount of dividend income that can be enjoyed tax-free was a major disappointment.
The decision to reduce the tax-free dividend allowance from £5,000 to £2,000 follows hot on the heels of the previous significant change to the taxation of dividends. The reduction is planned to take effect from April 2018.
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 largely mitigate the impact. It should certainly not be allowed to distract business owners from their longer-term financial goals.
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.
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 the company will pay more corporation tax, this will still amount to less than the income tax and employee and employer National Insurance contributions (NICs) payable on a salary.
One of the most obvious ways to mitigate the impact of the lower allowance 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payable on the contribution, any investment growth would be sheltered from tax, and 25 per cent of any sums eventually withdrawn from the pension scheme will also be free of tax.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 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.
The dividend allowance cut may not in itself be transformational but the strategies outlined above demonstrate the power of how the utilisation of legitimate tax reliefs can have a beneficial effect enabling individuals to enjoy their wealth to the full.