If you hold shares or funds outside an ISA or pension, the income they pay out — dividends — can be taxed. As with capital gains, the tax-free slice has been cut dramatically, so this now affects far more small investors than it used to.
What a dividend is
When a company makes a profit, it can pay some of it out to shareholders as a dividend. If you own shares or income-paying funds, those payments are a form of income, and above a certain point they are taxable.
The dividend allowance
Everyone gets a tax-free dividend allowance each year. Dividends within it are tax free; above it, they are taxed at rates that depend on your income tax band. The allowance has shrunk so much in recent years that a fairly modest portfolio held outside a tax wrapper can now generate a taxable bill.
Why this strengthens the case for ISAs
Dividends earned inside a stocks and shares ISA or a pension are completely free of this tax, no matter how large. That is the central reason to fill your ISA before investing in a general account — the shrinking allowances outside the wrapper make sheltering your investments more valuable every year.
Practical steps
- Use your full ISA allowance before holding investments in a taxable account.
- If you already hold shares outside an ISA, consider moving them in gradually.
- Spouses can hold investments in the name of the lower earner to use both allowances and lower rates.
- Keep records of dividends received, as you may need to report them.
The pattern is the same as with savings interest and capital gains: shelter first, and tax rarely troubles you.