Dividend allowance & contractor dividend tax

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Introduction -the tax-free dividend allowance 

The annual tax-free dividend allowance was introduced in the UK in April 2016 however, what is the dividend allowance? Please note this is a UK allowance and you can take this into account when you calculate your contractor dividend tax. Notably, this was quite a change to how dividends are taxed in the UK. Importantly, however, this has made the way that dividends are taxed much easier to follow.

Just like there is an annual personal allowance for your overall income, there is also a savings allowance for your savings income (interest) and an annual dividend allowance for your dividend income. When you have an income of a particular type that falls above the allowance for that income you will have tax due to HMRC.

As a contractor with your own limited company, when you take contractor dividends you will want to know how much dividend can I take tax-free. You may also wonder how much you will pay in contractor dividend tax.

Dividend allowance history and the previous dividend tax system

The annual dividend tax-free allowance was £5,000 in the 2016/17 tax year. Notably, this was kept in place until 2017/18 and then in 2018/19, the UK government reduced the tax-free dividend allowance (UK) to £2,000. It was the same in 2019/20 and then the dividend allowance 2020/21 was still £2,000. It also stayed at this level in 2021/22 and 2022/23. However, the dividend allowance is now reducing after 2022/23. As a result, the recent history of the UK dividend allowance has been:

Dividend
Tax year allowance
2016/17       5,000.00
2017/18       5,000.00
2018/19       2,000.00
2019/20       2,000.00
2020/21       2,000.00
2021/22       2,000.00
2022/23       2,000.00
2023/24       1,000.00
2024/25           500.00

Before April 2016, the dividend system that was in place was a tax credit system. Up to 5 April 2016 when you paid a dividend you would receive a contractor dividend tax credit. Notably, under this system, the dividends that a company paid were treated as 9/10ths of the gross. 9/10ths was the net dividend and 1/10th was the tax credit. Therefore, if your limited company decided to pay you £9,000, the gross dividend for tax purposes was £10,000. Please note that you would then take the £10,000 into account as part of your overall taxable income in your personal tax return. Dividend Tax Credits are no longer applicable for dividends received after 6th April 2016.

The change in April 2016 was a radical shake-up in how dividends are taxable. However, it has made the way these are taken into account in terms of taxable income much simpler. Therefore, it is now easier for the layman to understand.

Other guides

Before we move on, there are many aspects to paying contractor dividends. We have written about these on this website, and these include:

  • The annual dividend allowance (this article).

The tax-free dividend allowance –the UK dividend tax rates 

Now, let us consider how your dividends are taxable in the UK. In addition, let us also look at how much you can earn as income before you start paying taxes and when you do, how much UK dividend tax you will pay.

Please note that it is useful to know how much dividend you can pay yourself from your company at any moment in time. Every tax year, an individual has a personal tax allowance of £12,570 and a dividend tax allowance of £2,000. The £12,570 appears in your tax code, and this is applied to your salary on an ongoing basis.

It is also important to remember that how much dividend tax (UK) you pay will depend on how much dividends you earn within your overall income in the tax year in question.

Dividend tax rate (UK) -how to calculate your contractor dividend tax

The following sets out how the dividend tax rates (UK) apply to your income and how to calculate the tax on your contractor dividends:

  • Dividends are subject to tax only. This is unlike salaries, which are subject to Income Tax and National Insurance. 
  • How much dividend is tax-free? At present, the first £2,000 annual dividend allowance is tax-free. Therefore, this amount is the tax-free UK dividend allowance each tax year.
  • Any dividends that fall within your basic rate tax are taxable at 8.75%.  Please note that your basic rate band covers taxable income up to £50,270 pa.
  • Dividends that fall in your higher rates tax band (income from £50,270 to £150,000) are taxable at 33.75%. Please note that when your overall taxable income exceeds £100K, you will start to lose your personal allowance (PA) of £12,570. Notably, you will lose your PA by £1 for each extra £2 that you earn over £100K. Therefore, this means that up to £12,570 of your previously tax-free income is now taxable at the basic rate. Meanwhile, up to £12,570 of your income that was previously taxable at the basic rate is now taxable at the higher rate.
  • Any dividends that fall above the higher rates tax band (income above £150,000), the tax to pay will be at the additional rate. Please note that this is now 39.35%.

How the annual dividend allowance works 

The concession that came out back in April 2016 was the creation of a new annual allowance for dividends. Therefore, the £2,000 allowance is tax-free, regardless of what you earn.

Your personal tax allowance is currently £12,570. Please note that this appears in your PAYE code each tax year. Therefore, this is the amount you can earn as taxable income annually before you pay Income Tax.

The dividend tax allowance works similarly to your personal allowance. Under this, you can earn £2,000 in dividends annually before you pay tax. Similarly, there is also a tax-free allowance for interest income which is also part of investment income.

Therefore, on an annual basis, you can earn up to £12,570 in your overall taxable income before you pay Income Tax. In addition, you can also earn up to £2,000 in dividends before paying tax.

Examples -the tax-free dividend allowance & tax bill 

First example

Let us assume that your gross income in a tax year is just your salary, which is £50,270. In addition, you also receive a dividend payment of £2,000. As a result, this makes your total income £52,270. Therefore, we calculate your tax on the amount of salary that falls above your personal allowance:

Type of earnings Earnings Tax-free Taxable Taxable BR Taxable HR Tax rate Tax
Salary 50,270 12,570 37,700 37,700 20% 7,540.00
Dividend 2,000 2,000 0 0 0.00
7,540.00

As a result, the total tax bill you will pay via your Self-Assessment tax return will be £7,540.00.

Second example

In this example, you have a small business and are a company owner. First of all, you take a salary of £12,570. The minimum salary you need to count as a qualifying year for state pension purposes is £9,876. In addition, you also take £60,000 as contractor dividends. As a result, your total gross income will be £72,570. Therefore, your tax will be calculated on the amount of dividend that falls above your personal allowance:

Type of earnings Earnings Tax-free Taxable Taxable BR Taxable HR Tax rate Tax
Salary 12,570 12,570
Dividend 60,000 2,000 58,000 35,700 8.75% 3,123.75
22,300 33.75% 7,526.25
10,650.00

As a result, the total contractor dividend tax bill you will pay via your Self-Assessment tax return will be £10,650.00.

The Income Tax on your dividends and other taxable income, along with any Capital Gains Tax, is payable to HM Revenue & Customs every year via your Self-Assessment tax return.

Summary

Please kindly note that the above are two pretty straightforward examples. Key to mention, when there are different levels of salary and dividends, the tax band and rates interact, as described previously. Therefore, any part of your personal allowance that is spare, after considering your salary and any other income, can be set against dividends, in addition to your allowance for dividends.

Final thoughts

If you receive dividends through your company, you should consider how much you can take as dividends before you start paying tax. A key point, when your company is generating enough profits, it is advisable and tax-efficient to make sure that you draw enough dividends to use up your £2,000 tax-free dividend allowance.

Important to note that if you earn more than the amount that is taxable at the basic rate (£50,270), your £2,000 annual dividend allowance will still be tax-free. However, you will be paying higher rates of tax on the amount of other income that falls above the basic rates tax line.

Link to Contractor Advice UK group on

LinkedIn    https://www.linkedin.com/groups/4660081/

Published On: August 1st, 2022 / Categories: Dividends, Self-Assessment, Tax Saving Guides /

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