What are dividends, and how are they taxed?
Posted on 17th September 2020 at 12:09
If you're a limited company director and you withdraw dividends in addition to a salary, it's crucial to know how those dividends are taxed. If you already have an accountant it's likely they'll have gone through this with you, but if you're going it alone, you might find it all a bit overwhelming. Once you know the law surrounding dividend tax in the UK, you'll be able to make the most out of your earnings.
You're already likely to be taking a basic salary from your company tax-free, which for the current tax year (2020/21) is £12,500. Most companies will be making more than this amount in profit though, and if you're the only director, you are able to take most of that extra profit for yourself in the form of a dividend.
Generally, dividends are defined as a sum of money that is typically paid annually (or in other regular intervals) by a company. This money goes to a specific category of shareholders which is defined by the company's board of directors, or the sole director. Dividends can also be paid to investors in the form of shares rather than cash.
How are dividends taxed?
While taking additional earnings is a great perk of running a company, you should also consider that, just like in the case of any other earnings, you may have to pay taxes on dividends. The advantage of earning from dividends is that the tax rate for this kind of money is much lower than the one you have subjected to when receiving money from your normal salary.
Thanks to tax-free dividend allowances, you can start earning without having to pay taxes. Of course, once you have reached the allowance, then you will have to pay a percentage in taxes to HMRC.
In the tax year 2020/21, you don't need to pay taxes on the first £2,000 you earn from your dividends. This is known as tax-free dividends allowance, and it was actually as high as £5,000 until 2018! The tax-free dividends allowance can be coupled up with your tax-free personal salary allowance, which is £12,500 as previously mentioned. Additionally, you won't need to pay any taxes on dividends from ISA shares.
When you start earning more than £2000 from dividends, you will fall into a specific tax band or 'marginal tax rate' depending on how much you earn.
Firstly, there are three fundamental tax bands in the UK, and you will fall within one of them when you start earning more than £2000 in dividends - depending on how much you perceive per year. These are:
Basic rate = 7.5%
Higher rate = 32.5%
Additional rate = 38.1%
As an example, consider that you earn £3,000 in dividends and £29,500 from your 'normal' salary during a tax year. You will earn a total of £32,500. In the UK, you will have a tax-free personal allowance of £12,500, so the total income you have to pay taxes on is £20,000. Since this amount falls in the basic rate of tax, you will pay your normal taxes, plus 7.5% on £1000 in dividends (the other £2,000 you earn from this dividends is tax-free as it falls in the dividend allowance).
Paying taxes on your dividends is quite straightforward - but the process that you need to follow to pay your taxes depends on how much you earn:
If you're earning up to £10,000 in dividends...
For lower tiers, you will need to get in touch with HMRC through the helpline and request a tax-code change. Then, the tax you owe will be subtracted from your pension or wages.
If you're earning over £10,000 in dividends...
While you can still ask for information through the HMRC helpline, you will need to fill in a Self Assessment tax return form. Once you have completed the online tax return form, you will receive a letter which includes all the information you need to complete the process.
If you have no plans to get an accountant, you should start by understanding how much you have been earning this year through dividends. Then, get in touch with HMRC and fill in a self-assessment tax form if needed. You must do this before 31 January 2021. If you'd like us to help you get your finances in order for the rest of the year and 2021, feel free to get in touch with us today for a no-obligation chat.
Nicola J Sorrell -
Founder | Xero Champion | IR35 Expert
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