Receiving dividends from your investments has specific treatment within Income Tax. In the UK you have a Dividend Allowance: the first £500 you receive in dividends per year is completely free of tax.
Dividend tax rates:
- Above the exempt £500, you would pay tax depending on your Income Tax band.
- Basic rate taxpayers: 8.75%.
- Higher rate taxpayers: 33.75%.
- Additional rate taxpayers: 39.35%.
Accumulation vs Distribution Funds: In most of Europe, an accumulation fund (which automatically reinvests dividends internally) allows you to defer tax. In the UK this is NOT the case. HMRC requires you to pay tax on internally reinvested dividends as if you had received them in your account. This is known as 'notional distributions'.
You hold an accumulation fund and this year it has reinvested £1,000 in dividends internally. You have not seen that money in your bank account, but for HMRC you have just received £1,000. You would need to subtract the £500 allowance and pay the applicable tax on the remaining £500.
For this reason, outside ISA accounts, many UK investors prefer Distribution (Income) funds, as they make tax calculation and reporting to HMRC considerably simpler.