After a bruised 2020, dividend investors now face another curve – this time from the Chancellor.
In his budget, Rishi Sunak confirmed that the Treasury will increase taxes on dividends in April: investors will pay 1.25% more from April.
The hike, which could see investors paying an additional Â£ 3bn over five years, was part of Boris Johnson’s September plan to raise more money for the NHS.
Tax hikes: If an investor earns Â£ 10,000 in dividends next year, after factoring in their Â£ 2,000 allowance, their tax bill will increase by Â£ 100: 1.25% of Â£ 8,000
And while 1.25% doesn’t sound like a lot, experts say the move will affect older investors.
This is because many are looking for dividends (a style known as income investing) as a way to provide regular cash in retirement.
In addition, this measure will disproportionately affect investors who pay the base rate of income tax, i.e. the less well-off.
As always with taxes, the devil is in the details and requires an understanding of how the current system works.
In addition to their personal income allowance, all investors receive a dividend allowance of Â£ 2,000, with payments above those subject to tax.
Base rate taxpayers currently pay 7.5 percent on dividend income, while higher and additional rate taxpayers pay 32.5 percent and 38.1 percent. Starting in April, this will all increase to 8.75 percent, 33.75 percent and 39.35 percent respectively.
So if an investor earns Â£ 10,000 in dividends next year, after factoring in their Â£ 2,000 allowance, their tax bill will increase by Â£ 100: 1.25% of Â£ 8,000.
But for a base rate taxpayer, who currently only pays Â£ 600 in tax on that income, that’s a much larger jump than for a higher rate taxpayer (whose tax will drop from Â£ 2,600 to Â£ 2,700).
The news comes as the FTSE 100 is expected to pay out Â£ 84.1 billion in dividends this year, with the first signs pointing to a strong year in 2022. “UK dividends have generally recovered well from the pandemic,” says Nicholas Hyett of Hargreaves Lansdown.
âThe FTSE 100 currently offers a return – the percentage of your investment paid back in dividends – of almost 3.5%. “
Steelmaker Evraz and miner Rio Tinto are expected to lead the pack: with expected returns of 17.9% and 17.8% respectively.
Of course, similar payments are not guaranteed in 2022 and investors need to think carefully about how inflation might affect corporate earnings.
Divi grab: In his budget, Rishi Sunak (photo) confirmed that the Treasury will increase taxes on dividends in April: investors pay an additional 1.25% from April
That’s why investors take a close look at dividend coverage: which shows how many times the company might pay based on current profits.
âHistorically, income investors have also looked to defensive sectors, like consumer goods and pharmaceuticals when inflation rises,â Hyett said.
“These companies have strong brand power or are core goals, so they can pass higher costs on to customers.”
And how can investors minimize their tax bill?
For starters, any funds or stocks held in an equity ISA are exempt from dividend tax, as well as capital gains tax.
That’s why any financial advisor worth his salt will tell you to always use your annual ISA allowance of Â£ 20,000 – because once it’s gone you can’t get it back.
For long-term investors, however, it hasn’t always been this easy. Personal ISA allowances weren’t always as generous as they are now. In fact, less than 15 years ago they were only Â£ 7,200.
This means that many older investors will have accumulated nest eggs outside of their tax-free packaging – which have likely increased over time.
âEven if you have a large pot outside of your ISA, there are ways to lower your tax bill,â says Laura Suter, personal finance expert with the AJ Bell investment platform.
The overall strategy, she says, is to sell some of your stocks and then buy them back in an ISA (a move called “bed and ISA”).
âIf you do this now and then again in April when the new allocation begins, you could protect Â£ 40,000 before the new rate applies,â she says. “If you are in a relationship, you can effectively double your allowance: by sheltering Â£ 80,000 from the tax authorities.”
Getting it right, however, may require some planning, especially for those with larger portfolios.
If your stocks have appreciated in value over the years, you need to think about capital gains tax.
Investors currently receive an annual allowance of Â£ 12,300: any gain above this is subject to a 10% or 20% tax.
Remember, however, that this only applies to your actual gain: not the overall value of your assets.
Buying and selling shares will also incur the payment of a transaction fee (potentially around Â£ 9.95 per trade) to your investment platform.
As a result, Ms Suter recommends that, rather than moving among stocks or funds at random, investors should prioritize those who pay the biggest dividends.
âYou have to rank their assets from highest paying to lowest – focusing on the pounds and pennies rather than the percentage return,â she says.
Once the investments have been placed back into an ISA, all future gains and dividends are tax exempt.
Meanwhile, investors with available cash – and an ISA allocation – can reduce some of the risk of dividend hunting by looking at income-oriented funds. Experts at AJ Bell, for example, chose the Man GLG Income fund, which paid 4.76% last year.
The fund allocates investors’ capital to historically reliable dividend-paying stocks, including Shell, Rio Tinto, Imperial Brands and Barclays.
By reinvesting their dividends, investors could have turned Â£ 10,000 into Â£ 14,400 in five years.
With many platforms offering lower (or free) transaction fees on funds, this can prove to be a cheaper way to increase your income.
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