Month: April 2016

CGT and Dividend Tax Changes: Time to Review Your Strategy

The new tax year has brought important changes in the ways investments are taxed, including a considerable reduction in Capital Gains Tax (CGT) and a complete overhaul of dividend taxation. The scope of these changes merits a review of your investment strategy and portfolio structure. Although the conclusion for many investors will be that no action needs to be taken, make sure your investments remain tax efficient under the new regime.
Dividend Tax Changes
Let’s start with dividend tax changes, which have been known for some time and finally came into effect on 6 April 2016. Under the old system, which involved the somehow confusing 10% notional tax credit, effective dividend tax rates for basic, higher and additional rate taxpayers were 0%, 25% and 30.6%, respectively. On 6 April the notional tax credit was abolished and a new £5,000 dividend allowance was introduced, making the first £5,000 of your dividend income entirely tax free, regardless of your tax bracket (this is on top of any tax-free dividends received under a tax wrapper such as an ISA). At the same time, the rates applying to dividend income beyond the first £5,000 have increased by 7.5 percentage points. The new dividend tax rates for basic, higher and additional rate taxpayers are 7.5%, 32.5% and 38.1%, respectively.
In sum, these changes will result in most taxpayers paying more in dividend tax. The only exception is higher and additional rate taxpayers with relatively small dividend income, who might pay less tax overall thanks to the new allowance (even if your dividend income is a bit higher than the £5,000 allowance, e.g. £7,000, the average effective tax rate might still be lower than under the old regime).
Capital Gains Tax Reduction
While the dividend tax changes have been rather mixed, the changes in CGT, quite surprising and only announced in the 16 March Budget speech, are clearly positive. Effective from 6 April 2016, CGT rates fall from 18% to 10% for basic rate taxpayers and from 28% to 20% to higher rate taxpayers. Most taxpayers can benefit from the annual CGT allowance, which makes the first £11,100 of capital gains free of CGT (the amount for this year is the same as in 2015-16).
Income vs. Growth
In light of the above, the simple conclusion could be that taxation of capital gains has become lower, while taxation of dividends has become less favourable for most. Does this mean you should restructure your portfolio? Should you increase the weights of growth stocks (which tend to pay lower dividends and deliver most of their returns in capital gains) and sell some dividend stocks? If you invest in funds, should you change your focus from income funds to growth funds?
These are valid questions and you should be asking them, but keep in mind that the tax treatment of investments is only one of the many factors you should be considering when deciding your asset allocation and portfolio structure. There are many other factors, with some of them more important (and with much bigger potential financial consequences) than taxes – such as risk and diversification. To conclude, be prepared to make adjustments to optimise the tax position of your portfolio, but selling all income stocks and going all growth is probably a bad idea.
ISAs, Offshore Bonds and Other Options
Importantly, the above applies to direct investments in stocks or funds, but does not necessarily apply to investing via wrappers such as pensions, ISAs or offshore bonds. Particularly the latter has often been mentioned as an alternative in reaction to the dividend tax changes. While relatively simple (and completely legal and transparent, in spite of the “offshore” word), an offshore bond allows you to defer and reduce taxes payable, which may substantially enhance net return in the long run.
If your portfolio is relatively small, you are covered by the dividend and CGT allowances and probably don’t need to worry about taxes. However, with a larger portfolio and/or a longer time horizon, tax issues become a concern. Most people underestimate the effect taxes have on returns when compounded over longer periods of time.