Malcolm Finney provides us with an overview of the changes to the taxation of savings income.
The manner in which income tax on savings and dividend income is computed is perhaps surprisingly complicated. For the tax year 2015/16, a new 0% starting rate for savings was introduced, combined with a new starting rate limit of £5,000 (previously, the corresponding figures were 10% and £2,880). From April 2016, in addition, a new personal savings allowance of £1,000 is also to be introduced.
Savings and dividend income
Savings income for income tax purposes primarily consists of interest (e.g. bank interest). However, the term does extend to include less common categories including life assurance gains; purchased life annuity payments and the release of loans to participators (basically, shareholders) in close companies.
Savings income does not include dividend income, and the taxation of savings and dividend income is different.
Taxation computation
The rates of income tax applicable to savings income depend not only upon the amount of such income, but also the amount of other taxable income an individual may have. Thus, where an individual has non-savings income (e.g. self-employed earnings; employee salary) and also savings income (e.g. interest on a bank deposit) the latter is treated as the top slice of income and thus subject to income tax at the individual’s marginal rate of income tax (N.B. dividend income is treated as the highest part where both interest and dividend income arises).
Depending upon taxable income levels, savings income is subject to income tax (for 2015/16) at the 0% starting rate; the basic rate of 20%; the higher rate of 40%; and the additional rate of 45%. Dividend income is taxable at rates of 10% (the dividend ordinary rate), 32.5% and 37.5% (albeit with an offsetting tax credit of 10% of the gross dividend).
The personal allowance is £10,600 (individuals born after 5 April 1938; £10,660 if born before 6 April 1938).
The £5,000 starting rate limit
The newly introduced 0% starting rate for savings up to £5,000 suggests that the first £5,000 of savings income will always be taxed at 0% (i.e. is automatically tax-free). This, unfortunately, is incorrect. The reason is due to the manner in which income tax is computed (i.e. non-savings income is taxed first, then savings income).
Example 1: No savings income
Tom has a gross salary of £15,000.
His taxable income is £15,000 - £10,600 = £4,400.
Income tax charge = 20% x £4,400 = £880.
Example 2: Just savings income
Tom’s only income is £15,600 of gross interest income.
His taxable income is [£15,600 - £10,600] = £5,000.
Income tax charge = 0% x £5,000 = £0.
Example 3: Savings income plus non-savings income £15,600
Tom has a gross salary of £15,000 and gross interest income of £600.
His taxable income is [£15,000 - £10,600] + £600 = £5,000.
(N.B. the personal allowance is deducted first from his non-savings income, if possible).
Income tax charge = 20% x £4,400 + 0% x £600 = £880.
Example 4: Savings income plus non-savings income £18,000
Tom has a gross salary of £15,600 and gross interest income of £10,000.
His taxable income is [£15,600 - £10,600] + £10,000 = £15,000.
(N.B. the personal allowance is deducted from his non-savings income first).
Income tax charge = [20% x £5,000] + [20% x £10,000] = £3,000.
Examples 2 and 3 illustrate that in certain cases savings income of up to £5,000 is in fact taxed at 0% (as perhaps envisaged). However, Example 4 illustrates that because Tom’s non-savings income after deduction of his personal allowance equals £5,000, this in effect precludes the £5,000 starting rate band from applying, and the £5,000 savings income falls subject to the 20% rate.
Dividend taxation changes
Whilst no changes to the taxation of dividends apply to the tax year 2015/16, major changes are to apply from April 2016. In particular, the current tax credit system applied to dividends is to be replaced with a £5,000 tax-free dividend allowance. In addition, the current tax rates applicable to dividend income (see above) will be increased to 7.5% for basic rate taxpayers, 32.5% for higher rate taxpayers and 38.1% for additional rate taxpayers (but such rates are to apply to the net, not gross, dividend). Not surprisingly, there will be winners and losers.
Practical Tip:
Check to see whether your savings/dividend investment mix is still appropriate.
