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FOOL SCHOOL
How Interest And Dividends Are Taxed

December 10, 2003

We've already seen how income tax is payable on your salary or your pension income. Now let's look at the effect of investment income on the rates of tax. This is where the fun starts! Investment income is usually the interest you earn from your savings or the dividends you receive from holding shares.

Interest

Interest is usually taxed at source, the payer being mostly banks and building societies, deducting 20% then paying it over to the Inland Revenue. (Even though a person's income is in the 22% rate band, say from employment plus the interest itself, they are not liable to pay the additional 2%. The Inland Revenue lets you off that 2% -- lovely people that they are!)

Let's say you have a job earning 25,000 per year, well within the basic tax band, and you're also earning interest from a building society account amounting to 1,000 before tax (800 after the 20% has been deducted). Your total income will for tax purposes in the year be 26,000. Since this remains within the basic rate band, no further tax will be due, despite that fact that you are paying a marginal rate of 22% on the salary whilst the interest has suffered only 20% deduction at source.

But what if you have sufficient capital in the account to earn interest of 12,000 gross (9,600 net)? Your total income is now 37,000. Hello, higher rate tax of 40% on part of the interest. Remember that in Part I we pointed out that you could earn a total of 35,115 before you switched to the upper tax bracket of 40% tax? Well, you've now earned 1,885 over that figure so you will have to pay 40% on that element of income i.e. an extra 20% on top of what has already been deducted by the building society. Note that the interest has to be treated as the top slice of income -- the Inland Revenue will tax your salary first and then look at the income you may be getting from other sources.

The effect is that only a higher rate payer will have additional tax to pay on taxed interest.

At the other end of the spectrum, where you might be a non-taxpayer because your income is less than the personal allowance, you are allowed to reclaim the 20% tax that the building society has deducted. Alternatively you can fill in a special form that allows them to pay the interest to you gross.

Dividends

Dividends are even more complicated. They are not taxed at source like most interest, but carry a tax credit equivalent to 1/9 of the amount paid, or 10% of the grossed-up value. A tax credit is not the same as deduction at source because the paying company does not have to pay this credit over to the Inland Revenue.

The effect of this credit under the applicable rules is that no income tax is payable by any recipient of dividends whose total income is below the higher rate tax level, after adding in the grossed up value of those dividends. It is not a proper credit because, for example, a non taxpayer cannot recover it, unlike taxed interest where the tax deducted can be recovered in such circumstances. The sole exception to the spurious nature of the dividend tax credit is within Individual Savings Accounts (ISA) where the tax credit is recoverable by the plan manager. This benefit is due to be phased out in April 2004.

Where the dividends are received by higher rate payers, then additional tax of 25% of the amount paid, equivalent to 32.5% of the grossed up value becomes payable. Note that it is not 40%.

The effect of the rather odd situation with income tax on investment income can give rise to some quite startling results. Look at this:

Take the above individual where I calculated the tax on a person earning just below the higher rate tax band. The income was 35,115 and the tax was 6,474, a tidy sum to pay over.

Now supposing another person was fortunate enough, or could contrive, to earn the same amount, 35,115, in grossed up dividends, equal to cash received of 31,064. They would pay no income tax at all. Not a single penny.

Who said life was fair?