Dividend tax hike hits ‘entrepreneurial spirit of the nation’

Lauren Mason reports

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Prime Minister Boris Johnson’s announcement that dividend taxes will increase by 1.25% to fund social care reforms has been described as a “last-ditch attempt” to spread the costs across society, with members of the investment industry warning this could have a “huge knock-on effect on the entrepreneurial spirit of the nation”.

This comes shortly after Johnson’s address to the House of Commons yesterday (7 September), in which he introduced a new ‘Health and Social Care Levy’ which will raise approximately £36bn to be spent across the UK in order to prevent “catastrophic” care bills for the elderly and infirm.

The levy includes a 1.25% hike in National Insurance contributions from April next year, as well as a 1.25% increase in tax on share dividends.

The former has come under fire from Labour leader Keir Starmer as well as a number of Tory backbenchers, who argue that an NI increase will disproportionately impact younger workers and those earning lower wages.

“The UK government appears to have been spooked by the backlash over plans to increase National Insurance contributions to fund its radical social care reforms,” said Tom Selby, head of retirement policy at AJ Bell.

“Instead, the government has decided to badge up the tax increase as a 1.25% ‘Health and Social Care Levy’, with workers of all ages required to pay.

“Of course, the bulk of the working population are still under state pension age, meaning, in reality, this is a National Insurance hike in all but name and it is almost certainly still younger people who will pay the lion’s share of these costs.”

He added: “Increasing dividend taxation feels like a last-ditch attempt to convince voters that all sections of society are sharing responsibility for funding social care reform.”

Shaun Moore, tax and financial planning expert at Quilter, warned the combination of younger workers still facing a rise in NI and the older generations now subject to dividend tax increases could have a detrimental impact on the UK population in the short term.

“With bond yields and interest rates showing no sign of rising, investors and retirees have come to rely heavily on dividends to receive their income,” he pointed out. “As such, there is nowhere to turn for this group from this tax levy unless they invest smartly in tax-efficient savings vehicles such as ISAs and pensions.

“This policy, however, has wider ramifications and could have a huge knock-on effect on the entrepreneurial spirit of the nation. There are hundreds of thousands of directors of limited companies who pay themselves an income through dividends.

“This is a group that were locked out of any financial support during the pandemic and are now facing the double whammy of seeing their income hit just as the recovery takes shape and they try to find their feet once again.”

Indeed, research from AJ Bell shows that £600m will be raised from investors and the self-employed as a result of the dividend tax. Laura Suter, head of personal finance at the firm, agreed with Moore that it will mostly be company directors, the self-employed and contractors bearing the brunt of the hike, given that a £20,000 annual earning from dividends will equate to an extra cost of £225.

“Those who receive dividend income have faced a series of tax hikes in recent years, with the tax-free dividend allowance being slashed by 60% from £5,000 to £2,000 in 2018 and a rise in tax rates before that,” she said. “These successive moves means it has never been more beneficial for investors to put their money in ISAs or pensions and with generous £20,000 and £40,000 annual limits respectively, investors can start shielding money from the taxman right away.”

For those now seeking tax-efficient income, Moore said the options have become pensions or property “as the government has not yet decided to go after this wealth”.

Selby added that assuming the new levy operates in a similar way to National Insurance, pensions salary sacrifice “should become more attractive”.

“The increase in dividend tax means people investing outside tax-sheltered wrappers like pensions and ISAs should review their portfolios to make sure they are making as much use as possible of their annual contribution allowances to keep their tax bills as low as possible,” he warned.

Suter pointed out that, even for investors who have significant portfolios outside of a pension or an ISA, they will only be caught and face a higher tax bill if their annual dividends are over the annual dividend allowance of £2,000.

“To be in that position you would have to have a portfolio of over £50,000 if it was yielding 4% a year and the government estimates that around 60% of people who have dividend income outside of ISAs will not see a tax increase next year,” she reasoned.

Hargreaves Lansdown personal finance analyst Sarah Coles said: “Investors and business owners haven’t escaped the clutches of the taxman, who has swept them up in this tax grab, with a 1.25% rise in dividend tax. This will hit anyone holding investments outside an ISA, and people who run their own businesses and pay themselves dividends.

“Investors have had to crawl through a horrible dividend drought during Covid, and were just getting back on their feet, so this will feel like a particularly nasty attack on their income. Given that so many of them will also have a higher National Insurance bill, it deals them a double blow at a difficult time.”

She added: “It means it’s even more important to make sure you shelter as much of your investments as possible in ISAs, where all dividends are completely free of tax. With your money in an ISA, even if the government comes back for more further down the line, your investments are protected from tax.

“For investments held outside an ISA, after the tax-free dividend allowance of £2,000, you will face a higher tax bill. It means it’s worth thinking about the kinds of investments you hold within your ISA. If in any given year you have some investments in an ISA and some outside, it can be a good idea to put high income investments within the tax wrapper, where dividends are tax-free. Growth investments outside an ISA could be subject to capital gains tax, but this can be easier to manage and mitigate.”

For business owners, she explained, paying themselves dividends will often still be more tax-efficient than paying themselves more income, because even after the change, dividend tax will still be lower than the equivalent income tax.

“A basic rate taxpayer, for example, will pay 8.75% on dividends over their £2,000 dividend allowance. However, for all those who have struggled through the pandemic, being rewarded for their efforts with a higher tax bill is going to feel like a kick in the teeth,” Coles commented.