All taxpayers have an annual tax-free dividend allowance of £2,000, so only dividend income above this allowance is taxed.
The dividend allowance is in addition to your personal allowance, which is the amount you can earn each tax year before you have to start paying tax. In 2020-21 the personal allowance is £12,500. This means that if you receive £14,000 in dividend income this tax year, the first £12,500 could be covered by the personal allowance and the remaining £1,500 by the dividend allowance, so no tax would be payable (assuming you receive no other income).
Dividend income in excess of the allowance will be charged depending on your highest rate of tax, eg. In the example above if dividends totalled £20,000, after taking account of the individual’s personal allowance and their divided allowance of £2,000, £5,500 is taxable. This falls into the basic rate tax band and so is taxed at 7.5%, the rate applied to dividend income for basic rate taxpayers. If the taxable dividend income tipped into the higher rate tax band the rate of tax applied would be 32.5%, and for additional rate taxpayers incur 38.1%.
What does the dividend allowance mean for investors?
The introduction of the dividend allowance means that investment (stocks and shares) ISAs may appear less appealing to those with dividend income below £2,000. However, it’s worth remembering that your dividend income may rise above this limit over time, and any profit you make when selling investments in your investment ISA is free of Capital Gains Tax (CGT). Profits on investments held outside of an ISA are potentially liable for CGT. However, each tax year individuals have a CGT allowance, currently £12,300, so if you sell a non-ISA investment you will only be taxed on any profit above that amount.
ISAs can therefore increase the opportunity for tax-free returns over the long term, provided that they remain in their present form. You can invest up to £20,000 in tax-efficient ISAs in the 2020-21 tax year. You can use your full £20,000 allowance in an investment ISA, or split however you want across a cash ISA, investment ISA, lifetime ISA (max £4,000), and an innovative finance ISA. If you don’t use your allowance one year, it will be lost for good.
As well as the dividend tax allowance, there is also a personal savings allowance. This was also introduced in April 2016 and changed the way interest is taxed. For more information on how the personal savings allowance works, read our article ‘What is the personal savings allowance and what does it mean for you?’
You should bear in mind that tax rules can change in future and their effects on you will depend on your individual circumstances. The investments that you make can fall in value as well as rise; you might get back less than you invest.