Chancellor Philip Hammond has announced plans to make the tax-free dividend allowance less generous.
Under current rules, which were only introduced last April, there is no tax to pay on the first £5,000 of dividend income in each tax year. Dividends above that threshold will be taxed at 7.5% for basic-rate taxpayers, 32.5% for higher-rate taxpayers and 38.1% for additional-rate taxpayers.
But from April 2018 the allowance will be reduced from £5,000 to £2,000. The move will result in more investors being caught by the reformed dividend tax regime.
Currently, based on a yield of 3%, it requires a portfolio of £166,667 to generate £5,000 of dividend income. With a 4% yield, this figure drops to £125,000, and with a 5% yield it falls to £100,000.
Tax advantage of tax-efficient wrappers
From April 2018 on a 3% yield, the £2,000 of dividend income will be generated by a portfolio of £66,668. For a 4% yield the portfolio size will fall to £50,000 and for a 5% yield the portfolio size will fall to £40,000.
But it is worth remembering that all dividends generated within Isas remain free of tax and the Isa allowance is set to become even more generous in the 2017-2018 tax year, rising from £15,240 to £20,000.
So by taking full advantage of tax-efficient wrappers, most investors will not be affected by the new dividend tax rules.
Those with sizeable investments outside of an Isa, typically £50,000 or more, are likely to be caught by the allowance change, as are shareholder directors.
"It will ensure that support for investors is more effectively targeted, and make the total amount of income they can receive tax-free fairer and more affordable.
"This takes account of the increased Isa allowance, which will rise to £20,000 from this April, as well as further increases to the tax-free personal allowance which is additional to the dividend allowance," said the government.
Les Cameron, head of technical at Prudential, said the dividend allowance cut £2,000 will reduce the size of the portfolio that can be held tax efficiently by over 50%.
"As a result we expect to see an increase in the use of tax-efficient wrappers such as Isas, pensions and investment bonds as investors seek to mitigate their increased tax exposure," adds Cameron.
While 80% of investors are not expected to pay tax under the dividend regime, the biggest losers will be business owners who have hitherto paid themselves dividends as a more tax-efficient alternative to a salary.
Therefore, small businesses with a couple of employees, and individuals such as freelancers and contractors who run their own limited companies, will feel the pinch more than others.
This story was originally written for our sister magazine, Money Observer.