Are you leaking £4,096?

I never really thought about tax when I started investing. I used a stocks & shares ISA to get going because, yes, it made everything tax efficient but for me it was more about avoiding the mental load of timing share sales and paperwork than anything else. Back then in 2012, the capital gains allowance was £10,600 and over the years I watched that rise pretty steadily, joined by a new £5,000 dividend allowance in 2016. I was still tax efficient in my ISA but I’ll admit that, as a young investor putting away a modest sum every month and unlikely to even need those allowances, I did at times wonder if I’d ever really see the benefits of the ISA wrapper.

Cut to today and the scene looks very different. We’ve watched as the UK capital gains tax (CGT) allowance has fallen from £12,300 four years ago, to £3,000 today. The UK dividend tax allowance is now a tenth the level it was in 2016, sitting at £500. In both cases the tax we pay if we cross those thresholds is at the highest level since at least 2016. If, like me, you saw investment tax as something only the rich have to worry about, it’s maybe time we both had a fresh look.

Putting the new changes to UK dividend tax in context, an investor with a £12,500 portfolio paying out a 4% dividend would hit the £500 dividend allowance this year. Breach that level and the amount above the limit could attract 10.75% tax for basic-rate taxpayers (BRT), 35.75% for higher-rate taxpayers (HRT) or 39.35% for additional-rate taxpayers (ART).

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To illustrate that with a real-world example, let’s say we have one investor from each tax bracket. Before we do that - an important note: all the calculations and permutations you see are for purely informational purposes and neither you nor our imaginary friends should construe them as tax advice. If in doubt, chat to an independent financial adviser.

Now back to our regularly scheduled programming. Each of our theoretical investors holds a portfolio of shares worth £20,000 which, in our hypothetical world, will grow at an annual rate of 7% (in line with the historical average of the S&P 500 index) made up of 3% capital growth and 4% dividend income, which they reinvest. To keep it simple we won’t model for the effect of account fees, fund fees or other taxes related to jurisdiction, so this illustration is purely to see how those UK dividend tax rates look in real-life scenarios.

Leap forward a decade and, having started out with £20,000, our BRT now has £38,518. Our HRT has £36,699 and our ART has £36,443. Those annual UK dividend tax payments have weighed on our higher earners in particular but, if any one of them had used a stocks & shares ISA, that initial sum would have turned into £39,343 given we don’t pay any UK dividend tax, or UK capital gains tax for that matter, in an ISA.

Warning: UK dividend tax can seriously stunt your growth

Assumes 7% total return (3% capital growth, 4% dividend yield) on £20,000 over 10 years. Figures represent cash sums after all annual UK dividend tax payments have been paid. Source: Robinhood UK

It’s the same portfolio but ignoring the ISA account’s tax efficiency has cost our BRT £824, with our HRT missing out on £2,643 and our ART foregoing £2,900. And that’s before we factor in UK capital gains tax.

While our investors who haven’t used a stocks & shares ISA have been paying UK dividend tax each year, if they were to sell the whole portfolio after 10 years they’d have to figure out how much of their growth came from their shares gaining value, not just from dividend income. That’s because UK capital gains tax applies when you sell your shares, not throughout the journey. Bank more than £3,000 in gains from those share prices rising and you could be liable for the levy.

When we include the capital growth made on the original £20,000 and on the reinvested dividends, the tax bills go up even more: rising by £938 for our BRT, by £1,208 for our HRT and £1,202 for our ART. Add the two tax effects together and the gap looks all the wider.

Assumes 7% total return (3% capital growth, 4% dividend yield) over 10 years. Figures represent final cash sums after all UK dividend tax and UK capital gains tax payments have been paid.

The implied cost here is made up of:

1. UK dividend tax disappearing from these non-ISA accounts each year.
2. The compounding leak of missing out on growth that the reinvested money would have achieved, had it not been taxed each year.
3. The exit fee slapped on through UK capital gains tax when the investor sells the portfolio.

It’s the second one here that hits the hardest for me. It’s such a stealthy drag on long-term performance and, given we know just how important compounding is for investment returns, is a real silent killer. Together with the two other headline taxes, whose effects are bound to draw more investors into paying tax this year, it makes the case for considering a stocks & shares ISA now more than ever. Younger me might have wondered about how valuable the ISA’s tax efficiencies really are, older me has a pretty clear idea.

Important information

When investing, your capital is at risk. The value of your investments, and the income you receive from them, can go down as well as up and you may get back less than you invest. Forecasts aren’t a reliable guide to future results or returns.

Make sure to do your own research on what investments are right for you before investing or consider seeking expert financial advice. Please note that this article is meant for information and does not constitute any financial advice. This is not an offer, recommendation, inducement or invitation to buy, sell, or hold any securities, or to engage in any investment activity or strategy.

Robinhood doesn’t provide tax advice. You should seek advice if you have any questions regarding the impact your investments will have on your income tax and tax filing requirements.