A Closer Look at Taxing Interest and Dividends

Taxation of Interest

Many individuals earn interest from banks, building societies, or other sources. While tax may sometimes be deducted at the source, income tax is generally charged on the full amount of interest earned within a tax year, regardless of whether it is from UK or non-UK sources.

Income Tax Rates for Interest:

• Basic rate: 20%

• Higher rate: 40%

• Additional rate: 45%

Taxpayers may benefit from a Personal Savings Allowance (PSA), which exempts interest income up to a certain amount:

• £1,000 for basic rate taxpayers

• £500 for higher rate taxpayers

• Additional rate taxpayers are not eligible for the PSA.

Although referred to as an "allowance," the PSA operates as a nil-rate band, effectively reducing taxable interest within the stated limits.

0% Starting Rate for Savings:

A 0% starting rate applies to savings income up to £5,000. The eligibility for this rate depends on other sources of income. The threshold to benefit from this band is £17,570 (personal allowance of £12,570 + £5,000). If other income exceeds £17,570, the starting rate does not apply. Conversely, if other income is less than £12,570, the full £5,000 starting rate band is available.

Example:

Mr. Smith earns £14,000 from employment and £2,500 in bank interest. The personal allowance (£12,570) is deducted from his employment income, leaving £1,430 taxable at 20%. This reduces the £5,000 starting rate for savings by £1,430, leaving £3,570. Since the interest earned (£2,500) is less than the remaining starting rate band, it is all taxed at 0%.

Taxation of Dividends

Dividends, paid by companies from income already subjected to corporation tax, are subject to specific taxation rules. Similar to the PSA, there is a Dividend Allowance, which has decreased significantly over the years. For the 2024/25 tax year, the allowance is just £500.

Dividend Tax Rates:

• Basic rate taxpayers: 8.75% (ordinary rate)

• Higher rate taxpayers: 33.75% (higher rate)

• Additional rate taxpayers: 39.35% (additional rate)

Unlike the PSA, the dividend allowance is not reduced for higher or additional rate taxpayers. Dividends exceeding the allowance are taxed based on the taxpayer's income band.

Determining Applicable Tax Rates

The tax charged on interest and dividends depends on total income and other allowances. After deducting the personal allowance, PSA, dividend allowance, and considering the savings nil-rate band, any remaining chargeable income is taxed within the applicable bands:

1. Employment and self-employment income is taxed first.

2. Interest income is taxed next.

3. Dividend income is taxed last.

If other income sources are involved, seeking professional advice is advisable for accurate assessment.

Practical Tip

Each individual is entitled to a personal allowance, PSA, and dividend allowance. Married couples can maximize these allowances by transferring accounts or shareholdings to achieve a more tax-efficient outcome. However, it is essential to consider non-tax factors when making such decisions.

As always, careful planning and professional guidance can help minimize tax liabilities while ensuring compliance with tax regulations.

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