Laith Khalaf

Cuts to the dividend allowance mean the number of people facing tax on their dividends is soaring. HMRC forecast just under 3.6 million people will pay tax on their dividends this tax year, almost double the number who paid three years ago.

These aren’t simply fat cats or company bosses. Lots of small shareholders and basic rate taxpayers are being drawn into the tax net too. But despite cuts to allowances, paying tax on dividends can be avoided by many of those who the taxman is expecting to cough up.

Here are some tips to beat the dividend tax trap, though not all will be appropriate for every investor and investors should be particularly careful they don’t start letting the tax tail wag the investment dog.

ISAs

Probably your first port of call for avoiding dividend tax is a Stocks and Shares ISA.

Dividends received from investments held in these accounts are free from income tax and don’t take up any of your £500 dividend allowance.

You can set up an ISA with up to £20,000 in cash and buy investments within it, or you can carry out a ‘Bed and ISA’ transaction which moves existing investments into an ISA, by selling them and buying them back within an ISA wrapper, again up to a limit of £20,000 each tax year. This does crystallise any gains you’ve made on those investments though, which will count towards your capital gain tax allowance (currently £3,000) and could result in a capital gains tax charge if your profits exceed that amount.

Pensions

Pensions, including SIPPs, are another way to protect your dividends from the tax man. They are less flexible than ISAs because you can’t access your money until you hit age 55 (rising to 57 from 2028).

However, dividends in a pension can accumulate in the account without being subject to tax, and like in an ISA, they don’t take up any of your £500 dividend allowance.

You can also do a ‘Bed and SIPP’ to shield existing investments from dividend tax by selling them and buying them back within the tax shelter. Again, this potentially raises a capital gain tax liability if your annual gains exceed £3,000.

Use your dividend allowance

While the dividend allowance has been cut drastically, you can still receive £500 in dividends each year without paying tax on them.

Working out how much you can keep outside a tax shelter without paying tax is not a precise science, seeing as you don’t know exactly what dividends a company will pay, and they also tend to increase over time.

Usually the FTSE All Share yields somewhere in the region of 3.5%, so £500 of dividends from a UK tracker fund would equate to a capital holding of around £14,285 for an individual or £28,570 for a couple. Of course, that value and the dividends paid will fluctuate over time, probably trending upwards and requiring further action.

Buddy up

For married couples and civil partners, another option is to transfer investments from one partner to the other. This can reduce tax liabilities where one partner isn’t using their dividend allowance, has some free ISA allowance to shelter the shares, or simply sits in a lower tax band and so will be subject to less tax on dividends above the allowance.

It can be especially effective when one partner has large dividend payments which are pushing them up into a higher tax band.

Transfers of investments between spouses or civil partners aren’t subject to capital gains tax, and can be done ‘in specie’. This means simply changing the ownership of the investments rather than selling them and handing over in cash, which would potentially raise a capital gains tax liability.

VCTs

Buying VCTs at issue also means any dividends you receive from the underlying investments are free from dividend tax. However, VCTs invest in very early stage companies and so come with a high level of risk and limited liquidity.

They are therefore better suited to experienced, adventurous investors who have already maxed out on ISAs, and perhaps pensions too.

On the plus side you also get 30% up front tax relief, so for each £10,000 investment you can claim £3,000 back from the taxman, though you must hold the VCT for at least five years in order to keep the relief.

Don’t rely on accumulation units

Many funds offer accumulation units, which automatically reinvest dividends paid by companies in the portfolio without paying them out of the fund. But even though investors never see the dividends in their account, they are still taxable.

Your investment platform should provide you with an end of year tax certificate detailing all the dividends received by your investments, including accumulation units. But don’t get lured into thinking that just because you’ve bought accumulation units, you’ve avoided dividend tax.

Be careful with mixed asset funds

Some care also needs to be taken with mixed asset or multi-asset funds held outside of a SIPP or ISA.

These funds invest in a mixture of shares and bonds, and receive both dividends and interest from their underlying holdings. However, distributions made by the fund to investors are treated as dividends or interest, depending on the asset allocation of the fund.

If the fund invests more than 60% in bonds and cash, then payments from the fund are classed as interest, if the fund invests less than 60% in bonds and cash, they are classed as dividends. That’s even though a significant portion of the distribution could come from bond and cash interest.

In practice it’s only the most cautious multi-asset funds where payments to investors will be classed as interest, with the majority being treated as dividends. So these will need to be added to the tally when calculating if you need to pay dividend tax.

Of course care also needs to be taken with those paying interest too, as these payments are also taxable, but under different rules. Like with bank interest, distributions from such funds are covered by the Personal Savings Allowance, which is the amount of interest you can receive each year tax-free.

That allowance is £1,000, £500, or £0 depending on whether you are a basic, higher or additional rate taxpayer (lower earners may also receive up to £5,000 more tax-fee interest under the starting rate for savings).

Interest received above the Personal Savings Allowance is taxed at income tax rates of 20%, 40% and 45%, which are more punitive than dividend tax rates of 8.75%, 33.75% and 39.35%.

Cut dividend payers

Another option is to reduce exposure to dividend payers in your portfolio and swivel towards growth funds and stocks, but you might find yourself jumping out of the frying pan into the fire.

Growth is liable to capital gains tax, and again here the annual tax-free allowance has been drastically trimmed back, to £3,000 a year. Gains above this level are taxable at 10% for basic rate taxpayers and 20% for higher rate taxpayers.

That’s for the time being – it’s possible the new Chancellor will seek to raise capital gains tax rates in her October Budget.

You do have more discretion over when you pay tax on gains as they are only crystallised when you sell, whereas dividends are paid year in year out based on fund and share distribution schedules.

However, by cutting dividend payers from your portfolio you are definitely in the danger zone of letting the tax tail wag the investment dog, potentially ending up with an unbalanced portfolio that could be more volatile. So it’s really only to be considered by those who already have too much exposure to dividend funds and stocks and need to trim back anyway

Given the popularity and strong performance of growth stocks over the last decade, that’s likely to be a small huddle of investors.

Laith Khalaf is head of investment analysis at AJ Bell