Dividends are an important source of income for shareholders of limited companies. However, it's crucial to understand the tax implications associated with dividends. In this article, we will provide a comprehensive guide on how dividends work, reporting and paying dividend tax, and the tax-free allowances available for shareholders.

What is a Dividend?

Dividends are payments made by limited companies to their shareholders using the profits remaining after paying Corporation Tax. These payments are tax-efficient and do not attract National Insurance contributions, making them an attractive method for shareholders to extract money from their companies.

Who Can Receive Dividend Payments?

Dividend payments are typically made to shareholders of a company, which can include investors, employees, directors, or their relatives. It is common for individuals to hold both the role of a shareholder and a director, particularly in smaller businesses.

How Much Tax Will I Pay on Dividends?

The amount of tax you pay on dividends depends on your total income and the portion derived from dividend payments. The advantage of dividends is that they do not incur National Insurance contributions. Many directors who are also shareholders choose to pay themselves a combination of a small salary and dividends to optimise their tax efficiency.

Tax-Free Allowances for Dividends

Fortunately, there are tax-free allowances that can help reduce the amount of dividend tax payable. These include the Personal Allowance and the Dividend Allowance.

The 2023/24 Tax-Free Personal Allowance

The Personal Allowance is the amount of income an individual can earn before being liable for income tax. In the tax year 2023/24, the Personal Allowance is set at £12,570. This allowance applies to the total income earned, including dividends. Thus, if your only income for the year is a £10,000 dividend payment, you will not need to pay any tax on it.

The 2023/24 Dividend Allowance

The Dividend Allowance is the amount of dividends an individual can earn tax-free in a year. It is separate from the Personal Allowance, and both allowances can be utilised simultaneously. The Dividend Allowance for the tax year 2023/24 is £1,000. This allowance will decrease to £500 in the 2024/25 tax year, as announced in the Autumn Budget statement in November 2022.

Using the Tax-Free Allowances

To illustrate the utilisation of tax-free allowances, consider the following examples:

Your only income in the 2023/24 tax year is a £13,570 dividend payment. You can use the full Personal Allowance (£12,570) and the full Dividend Allowance (£1,000) against the dividend amount, resulting in no tax payable.

In the 2023/24 tax year, you earn a salary of £10,000 and receive a £5,000 dividend. Your salary uses part of your Personal Allowance, leaving £2,570 remaining. You can apply this leftover amount against the dividend payment, resulting in a taxable amount of £1,250 (£5,000 - £2,750). This remaining amount will be subject to dividend tax.

Dividend Tax Rates in 2023/24

The rate of dividend tax you pay depends on the tax band you fall into, which is determined by adding your total income, including dividends, to any other income received. The tax rates and thresholds for the tax year 2023/24 are as follows:

Personal Allowance: 0% tax rate for income in this band (£0 - £12,570)

Basic-rate taxpayers: 8.75% tax rate (£12,571 - £50,270)

Higher-rate taxpayers: 33.75% tax rate (£50,271 - £125,140)

Additional-rate taxpayers: 39.35% tax rate (£125,140 upwards)

These rates represent the percentage of dividend income that will be subject to tax within each respective tax band.

Paying Dividends: When and How?

You have flexibility in terms of when and how you pay yourself dividends. Most companies opt to pay dividends on a quarterly basis, although some may choose bi-annual or annual payments.

To declare dividends, you will need to hold a directors' meeting and record the declaration in the minutes, even if you are the sole director. Each dividend payment should be accompanied by a dividend voucher containing details such as the date, company name, shareholder names, and the dividend amount.

Understanding dividend tax is crucial for shareholders of limited companies. By grasping the basics of dividends, tax-free allowances, and tax rates, you can make informed decisions regarding your income and tax planning. Always consult with a qualified professional to ensure compliance with tax regulations and to optimise your financial arrangements.