The ‘dividend allowance’ was put in place in April 2016 – it means that the first £2,000 of dividends you receive are tax-free. But how does this allowance work in practice for company owners?
The allowance was implemented in April 2016, as part of a radical shake-up in the way dividends are taxed.
Prior to this date, under the tax credit system, dividends were paid to shareholders net and multiplied by 10/9 to produce the gross dividend upon which dividend tax was levied.
Dividends are now taxed at a flat rate, according to the tax band they fall into – Basic Rate (7.5%), Higher Rate (32.5%) and Additional Rate (38.1%).
The one concession was the creation of a tax-free ‘dividend allowance’ applied to the first £5,000 of dividend income.
However, from April 2018, the allowance was cut to just £2,000.
This means that the first £2,000 of dividend income you receive is not taxed at all, but significantly, this sum still sits within the relevant tax band for overall taxation purposes.
How does the dividend allowance work in practice?
Here is an example of how this tax concession works for a limited company owner drawing down a £12,500 salary and £50,000 dividends during the 2020/21 and 2019/20 tax years. You can input your own salary/dividend mix into our dividend tax calculator.
- The £12,500 salary takes up the entire 2019/20 tax-free personal allowance.
- The first £2,000 of dividends is tax-free, due to the dividend allowance.
- The next £35,500 of dividends are taxed at 7.5% (basic rate) = £2,662.50.
- The remaining £12,500 dividends are taxed at 32.5% (higher rate) = £4,062.50.
- The total dividend tax liability is £6,725.
Notice how the £2,000 dividend allowance is tax-free, but still takes up the first £2,000 of your basic rate tax band (£0-£37,500 during 2020-21 and 2019-20).
How much did the dividend allowance reduction cost you?
The dividend allowance was reduced from £5,000 to £2,000 from April 2018 onwards – just two years after it was first implemented. How you are financially affected by the cut depends on which tax band the first £5,000 of dividends fall into.
If they fall into your basic rate band, you are £225 worse off (7.5% basic rate dividend tax x £3,000). The cut cost higher-rate taxpayers £975, and additional-rate taxpayers £1,143.
Of course, should the first £5,000 of dividends fall between two tax bands, the total tax hit will vary from the above figures.
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According to the Budget documentation, the allowance cut is expected to raise an extra £800m to £900m per year for the Treasury.
You can download a Government explanation of the dividend allowance reduction (published following the Spring Budget 2017).