Making sense of dividends

Companies that are doing well pay out extra money, called dividends, to shareholders. However, the amount can be taxed depending on how much money you earn

In order for a company to grow, it can sell little pieces of itself, through what are known as shares. Many well-known businesses such as Microsoft, Amazon and Shell are listed on stock markets, which means people can buy shares in these firms. If you invest in a company that makes a profit, it could pay you a chunk of this profit.

There are two ways you can earn money from shares. The first is if the company you’ve invested in makes money and starts to grow, it will be worth more and the share price will rise. The second way is if the company you are invested in pays its shareholders money at the end of the year out of its profits – in what is known as a dividend.

How dividends work
When a company listed on the stock exchange has reached a certain level of maturity and scale so it is generating reliable revenue, profit and cash flow, it may decide to start paying dividends to shareholders.

Dividends are a portion of a company’s profit that they choose to pay shareholders as a reward for their investment. Typically, companies pay out dividends twice a year, although some firms will pay out on a quarterly basis. The details are usually revealed in first-half and full year results.

The amount you get paid from a dividend depends on how many shares you own and how well the company is doing. Both private and public companies pay dividends, but not all companies choose to pay them. Dividends are typically paid out in cash but can also be paid out in the form of stock or other assets.

Paying tax on dividends
Dividends are a great way of receiving regular money from your investments. However, if you receive a dividend it is counted as part of your income, which means you may have to pay tax on it.

How much tax you pay will depend on how much you have earned from your dividend. You don’t need to pay any tax on dividend income on the first £2,000 you receive – also known as the tax-free dividend allowance – for the April 2022/23 tax year, even if you’re a higher or additional rate tax payer.

In April 2023 the tax-free dividend allowance will fall to £1,000 and then drop again to £500 the year after. The tax rate you pay on dividends above the allowance depends on your income tax band, which you can work out by adding your total dividend income to your regular income.

In April 2022, the dividend tax rates increased by 1.25%. Here are the new rates:

• 8.75% for basic rate taxpayers (from 7.5%)
• 33.75% for higher rate taxpayers (from 32.5%)
• 39.35% for additional rate taxpayers (from 38.1%)
On top of this there is also the personal allowance, the amount you can earn each year without having to pay tax, which is £12,570 for the 2022/23 tax year. This means that if your only income is from investments, you won’t have to pay tax on dividends up to £14,570.

So if you received a payment of £14,000 in dividends from your shares, the first £12,570 would be covered by the personal allowance. The remainder would be covered by the dividend allowance, so you would pay no tax.

How can I be more tax efficient with my shares?
You will need to assess your tax obligations on your investable income. If your shares or funds are held in a tax-efficient product such as a stocks and shares ISA or a pension, they will allow you to buy and sell shares without having tax, so you don’t have to worry about tax thresholds.

You don’t need to inform HMRC if your dividends are within the tax allowance for the year. Basic rate payers who receive dividends of more than £2,000 will need to complete a self-assessment return.