A seemingly simple change to dividend tax is causing a huge headache for investors who have large equity portfolios. We’ve spoken to the experts to find out how you should balance income and growth investments while protecting your hard-earned cash from the taxman.

Understanding the changes

Before 6 April 2016, investors were paid dividends with a notional 10% tax credit applied. This meant basic rate taxpayers effectively received dividend income tax-free, while higher earners paid an extra 22.5% of tax through their tax return.

The tax credit has been replaced by a £5,000 annual dividend allowance. If you receive dividends above this threshold, the excess is taxed at 7.5%, 32.5% or 38.1% depending on whether you’re a basic, higher or additional rate taxpayer.

The changes mean lower earners who are reliant on dividends for their income stream - such as retired investors who have large equity portfolios - could pay more tax under the new regime. A basic rate taxpayer who gets £10,000 of dividends will get a tax bill of £375; before 6 April they would have had no tax due, according to PruAdviser.

Higher rate taxpayers who pay themselves more than £21,667 in dividends each year will also be worse off. If you’re a higher earner who receives dividends of £26,000 you’ll pay £6,825 under the new regime compared with £6,500 under the old regime.

Next steps

If you’re likely to pay more dividend tax this year you might be tempted to switch your investments from income paying ones to growth-focused ones, but this isn’t necessarily a good idea.

Rob Morgan, pensions and investments analyst at Charles Stanley, says investors should never let the ‘tax tail wag the investment dog’. In other words, you shouldn’t change your investment strategy just for the sake of reducing tax. If you can’t find ‘like for like’ assets you could inadvertently increase or decrease your risk profile, and dividend flow could be important to maintain your lifestyle requirements.

‘Your investment objectives and potential overall returns should take precedence,’ Morgan says.

It’s still important to consider how tax-efficient your portfolio is, but you need to look at it from the point of income tax, capital gains tax (CGT) and dividend tax. Your first step should be to use up your ISA allowance each year. Investments held inside an ISA are free from all of these taxes.

Checklist

If you have assets above the ISA allowance you’ll need to decide which investments should be held inside the wrapper and which should held outside. Morgan says there are lots of factors to think about:

• Your other income - your overall income will dictate the rate of tax you pay on dividends.

• What extent you are already using up tax allowances - your income tax personal allowance, dividend allowance of £5,000, savings allowance of £1,000 for a basic rate tax payer, and CGT allowance of £11,100.

• How regularly you trade - if you buy and sell regularly you will be crystallising gains and losses on a regular basis. Depending on the size of these it may mean these assets are best held in an ISA to avoid CGT. However, if your portfolio is smaller and you don’t think you will exceed the £11,100 annual CGT allowance you could be better off holding yielding assets in the ISA so to minimise income tax.

• The interaction between income tax and CGT - the amount of taxable income you have dictates the rate of CGT on gains.

There is no one-size-fits-all policy, but many experts recommend holding income-generating investments in an ISA and growth ones outside. This is because you can plan when to lock in profits on gains but you can’t choose when to take taxable investment income. CGT rates were recently reduced to 10% for basic-rate taxpayers and 20% for higher-rate taxpayers, which strengthens the case for this approach.

Jason Hollands, managing director, business development and communications at Tilney Bestinvest, says investors with assets outside an ISA should periodically crystallise gains using the annual CGT allowance.

‘Unless a disposal takes place the annual allowance is never called upon, nor can it be carried forward to future years; effectively a valuable benefit lost. As a result, many investors are hit with sizeable tax liabilities when they eventually come to surrender and/or transfer long-held assets to children,’ he explains.

Dividend migration

The rates of CGT are lower than for income tax, so if you have high levels of taxable income from various sources and have already used your ISA allowance it could be worth migrating some of your assets from dividend paying assets to those that produce a predictable capital gain.

If you switch investments you need to be careful that you don’t breach the CGT allowance. There are also charges involved in buying and selling shares, plus bid offer spreads, so you need to ensure you don’t end up worse off.

Another danger is the Government could change the CGT rate. It’s low at the moment, but there’s every chance it could be hiked in the future.

‘The rate of CGT changes all the time; it probably won’t be this low in five years’ time. If you predicate your approach around tax you could get derailed. This is why you need a portfolio approach,’ explains Rob Burgeman, divisional director of investment management at Brewin Dolphin.

Income vs growth

If you’re considering making changes to your portfolio it’s also worth thinking about the income versus capital growth debate. Burgeman says if you’d invested in the FTSE 100 on a capital growth basis since 2000 you’d be sitting on a 2.4% loss. On a total return basis - which includes capital gains and dividends - you would have made a near 70% return.

Andrew Feldhaus, investment manager at Redmayne Bentley, says capital growth can be less predictable than dividend payments, which tend to have a regularity in terms of timing and payment date.

‘Quite often, capital growth or return is driven by market sentiment, which is far less predictable and can lead to increased volatility in terms of performance,’ he says.

On the flipside, it can be dangerous to solely focus on income. Jackie Neill, former fund manager and creator of stock market board game BuySellorHold, says very high yields are often danger signals. They can show that a company is in difficulty or that the stock market perceives it to be.

‘Focusing on a high income and ignoring other factors is a far riskier approach than focusing on total return and strong underlying investments,’ says Neill.

Tax relief

Philip Rhoden, co-founder and director of broker Clubfinance, suggests another way to minimise dividend tax is to make investments that provide income tax relief - you effectively get the tax back on the dividends.

‘Pension contributions are the obvious example, although the amount you can contribute can be very limited, especially for high earners, and there is also the lifetime limit to factor in,’ he says.

An alternative is venture capital trust (VCT) and enterprise investment scheme (EIS) qualifying shares, which offer 30% income tax relief.

Seed EIS and EIS offer CGT relief or deferment respectively. Dividends on VCTs are tax-free for the first £200,000 you invest each tax year.