How much tax do you pay on dividends?

Taxation of dividends in the UK has always been confusing. The rates people mention are actually different from the effective rates for some legacy reasons. As if tax was not complicated enough...

There used to be 2 dividend tax rates but this changed last year. There are now 3 different rates depending on your tax band. And with the introduction of the new band at 50% called top rate income tax threshold a new band was introduced as well for dividends. Here they are:

• 10% on dividends for income received below the higher rate income tax threshold (£37,400)
• 32.5% on dividends for income received above the higher rate income tax threshold
• A new 'additional' dividend tax rate of 42.5% applies to individuals earning £150,000 or more from April 6th 2010 onwards.

However the calculation is a bit convoluted. The actual rate of tax you pay in dividends is lower than these headline rates, as dividends automatically receive a 10% tax credit. This is to take into account the fact that you will already have paid corporation tax on your company profits.

So, for lower rate taxpayers, the tax credit cancels out the tax and in effect you pay no tax at all on dividends. For higher rate taxpayers, the dividend tax liability comes out to 25% when you factor in the tax credit. And for any dividend income falling within the new additional rate band, the effective tax rate on that income is 36.1%.

Update 2013: The reduction of the additional band income tax rate from 50% to 45% came into effect in April 2013. To be consistent, the top dividend rate was reduced as well from 42.5% to 37.5%. The corresponding effective tax rate was therefore reduced from 36.1% to 30.5%.

Update 2015: Major changes to dividends taxation were announced in the summer 2015 budget. For more details please refer to this article.