or Should the Tax Tail Wag the Investment Dog?
I am indebted to Aviva, whose technical department posted the calculations bit of this blog on their information for advisers site.
I've been asked a number of times already how I'll be changing portfolio make up with the new dividend allowance. It's one of those things that makes a great headline and an even better exam question.
However, we should remember that we don't want the tax tail to wag the investment dog.
Over to Aviva for a bit for some number crunching examples...
As announced in the July 2015 Summer Budget the taxation of dividend income was set to change from 6 April 2016. People are now taxed on the actual dividend they receive. The old system of receiving a net dividend with an attaching 10% credit and grossing up no longer applies. In this Bulletin we look at how the system now operates and considers planning opportunities to maximise its benefit.
Facts and Analysis
If an individual’s total dividend income in 2016/17 is less than £5,000 then no tax will be due. On any dividends over £5,000 tax will be paid on the excess at the following rates:
Type of taxpayer
|
Tax %
|
|---|---|
| Basic rate taxpayer | 7.5% |
| Higher rate taxpayer | 32.5% |
| Additional rate taxpayer | 38.1% |
Taxpayers marginal rate of income tax
| Up to 5 April value of net £1,000 dividend | Post 6 April value of £1,000 dividend within the tax free allowance |
Extra available
|
|---|---|---|---|
| Higher rate taxpayer | £750.00 | £1,000.00 | £250.00 |
| Additional rate taxpayer | £694.50 | £1,000.00 | £305.50 |
Importance of reviewing tax wrappers
As the new tax free dividend allowance can make a significant difference to investment returns its introduction should be used to review the appropriateness of tax wrappers. Particularly giving consideration to the taxation of the underlying asset classes within a portfolio to ensure the portfolio is held as tax efficiently as possible. The following simplified example illustrates the benefit of such a review.
Example Mr Smith
Mr Smith is a higher rate taxpayer, over the recent years he has invested maximising his ISA allowances and now has a total portfolio made up between ISA and directly held collectives as follows:
Asset class
| ISA |
Directly held
|
|---|---|---|
| Equities: dividends/capital growth | £75,000 | £75,000 |
| Gilt, bond funds: savings income | £75,000 | £75,000 |
| Total | £150,000 | £150,000 |
| Tax Wrapper | Income |
Gross
|
Tax
|
Net
|
|---|---|---|---|---|
| ISA | Savings income £75,000 (3% gross) | £2,250.00 | Nil | £2,250.00 |
| ISA | Dividend income £75,000 (3.25%) | £2,437.50 | Nil | £2,437.50 |
| Directly held | Savings income £75,000 (3% gross) | £2,250.00 | £900.00 | £1,350.00 |
| Directly held | Dividend income £75,000 (3.25%) | £2,437.50 | Nil | £2,437.50 |
| Total | £9,375.00 | £900.00 | £8,475.00 | |
Realigning asset classes to the most appropriate tax wrapper
For tax year 2015/16 the dividends received within the ISA saved a 32.5% liability on the notional gross dividend and a 40% liability on the gross savings income.
In 2016/17 Mr Smith’s dividend income is less than £5,000 so he would be better to maximise the tax free dividend allowance by holding all the dividend generating funds directly. In addition, the directly held funds paying savings income suffering 40% tax will benefit from being held within the ISA wrapper. Assuming the ISA and Investment Account are platform based and have access to the same funds this realignment can be easily achieved by switching the dividend generating funds in the ISA to the income producing funds in the Investment Account and visa versa. The realigned portfolio would be as follows:
| Tax Wrapper | Income |
Gross
|
Tax
|
Net
|
|---|---|---|---|---|
| ISA | Savings income £150,000 (3% gross) | £4500.00 | Nil | £4,500.00 |
| Directly held | Dividend income £150,000 (3.25%) | £4,875.00 | Nil | £4,875.50 |
| Total | £9,375.00 | Nil | £9,375.00 | |
Capital gains tax
When switching the directly held funds so future dividends will benefit from the £5,000 tax free allowance consideration has to be given to any potential capital gain tax implications. Going forward holding all the equity based funds outside the ISA also gives the opportunity to manage and realise gains to maximise the capital gains tax annual exemption year on year.
Personal savings allowance
Mr Smith also holds a £50,000 cash reserve in bank and building society accounts so he will benefit from the new personal savings allowances which were introduced on 6 April 2016. This will ensure that the interest he receives (assuming annual rate of return of 1%) will be tax free up to the £500 pa limit for higher rate tax payers.
Summary
Mr Smith has cash and investments totalling £350,000. Careful planning maximising the new tax free dividend allowance, the personal savings allowance and managing capital gains within the annual exempt amount means he is unlikely to pay any tax his investments during 2016/17. The example shows significant tax savings can be made by aligning asset classes within a portfolio to the most efficient tax wrapper.
Back to me... So that's all well and good in the theoretical example. But what if the funds now held outside of an ISA do really well?
Then the larger gains may be outside of the ISA tax efficient wrapper and because of the size of the fund, or because CGT allowance is used elsewhere (selling a second home for example), now subject to tax, thus wiping out any gains from reallocation in the first place.
It's one of those things that is only really going to be known with hindsight.
So we will continue as we always have done, allocating to assets and tax wrappers for our clients in the best possible way - on a personal basis for them - considering all the outcomes we can and whilst we always adapt and adjust to new information , regulation and taxation, we will also ensure that the tax tail is not wagging the investment dog.
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