Dividends are how many of the world's wealthiest people make most of their money. For example, did you know that Facebook owner Mark Zuckerberg has a salary of only $1 per year? But he still remains one of the world's richest people. And it's all because of dividends.

Dividends are financial rewards for investments made into successful businesses. When companies do well, the shareholders get paid in dividends. This, of course, is a source of income for many people and dividend tax is levied on the earnings they make from their dividends.

But how exactly do dividends work? Who decides how much they payout? How do you buy dividends? And how much tax do you pay on them once they payout?

We are going to answer all this more as we explore dividends and dividend tax.

The amount of tax you pay on dividends is fixed by the Income Tax rates and which Income Tax band you are in. Those on the Basic Rate (20%) of Income Tax pay 8.75% on dividends, while people on the Higher Rate (40%) pay 33.75%, and those on the Additional Rate (45%) pay 39.35% on their dividends.

There are also tax-free allowances on dividends that are determined by the year in which the dividend was paid out, with the current allowance being at £2,000. If you are the recipient of dividends that exceed the tax-free allowance, you must inform HMRC of the dividend income you have received and pay the necessary taxes.

So let's jump in and take a closer look at what dividends actually are.

Dividends refer to the financial distribution of a company's profits to its shareholders.

Companies are funded in part by shareholders who invest their own money into the company with the expectation that the company will then perform well and their investment will yield financial rewards.

When a company earns a profit and is successful, it pays a portion of the profits in dividends to shareholders. Anything that is not distributed amongst the shareholders is re-invested into the business.

Dividends may be paid out in cash or they can be paid by the issuing of further shares or even company assets.

Any dividends received by shareholders are regarded as income and are subject to taxation (if they exceed the dividend allowance). Companies are not taxed on any of the dividends that they payout.

Dividend Allowance refers to the amount of money you can earn from dividends before you pay Dividend Tax on them.

The current tax-free Dividend Allowance is £2,000 for any dividends you receive between April 6th 2022 and April 5th 2023.

The same allowance goes back to the tax year between 2018/2019. Prior to that, the Dividend Allowance was £5,000.

Dividend allowance rates

Tax yearDividend allowance
6 April 2022 to 5 April 2023£2,000
6 April 2021 to 5 April 2022£2,000
6 April 2020 to 5 April 2021£2,000
6 April 2019 to 5 April 2020£2,000
6 April 2018 to 5 April 2019£2,000
6 April 2017 to 5 April 2018£5,000
6 April 2016 to 5 April 2017£5,000

The amount of tax you pay on your dividends above the allowance depends on which Income Tax band you are in.

So, to work out how much tax you must pay on your dividends you must first determine which Income Tax band you are in:

Income Tax bands 2022

Income Tax bandTaxable incomeTax rate
Personal AllowanceUp to £12,5700%
Basic Rate£12,571 to £50,27020%
Higher Rate£50,271 to £150,00040%
Additional Rateover £150,00045%

And from there, you can work out the tax rate you will pay on your dividend earnings.

Dividend Tax rate

Income Tax bandTax rate on dividends
Basic Rate8.75%
Higher Rate33.75%
Additional Rate39.35%

To use an example, if you make £3,000 a year in dividends and earn £29,570 as your salary, you will have a total income of £32,570.

The Personal Allowance for Income Tax is £12,570. So take this away from £32,570 and you are left with £20,000.

As this is in the Basic Rate tax band, you will pay:

  • 20% tax on £17,000 of wages (£20,000 of salary - £3,000 of dividends)
  • no tax on £2,000 of dividends, because of the dividend allowance
  • 8.75% tax (Basic Rate) on £1,000 of dividends.

It is important to note that your Income Tax band includes any earnings you make from dividends. So if your dividend earnings take you from on band up to another, you will then have to pay the rate of the new band you are in.

For example, if you make £50,000 per year from your salary and receive an additional £20,000 in dividends, this takes your overall income to £80,000. As £80,000 is in the Higher Rate of Income Tax band, you will pay 40% on everything over £50,270 and the Higher Rate of dividend tax on your dividends.

The way in which you pay tax on your dividends depends on how much your dividends are worth. Anything over £10,000 is paid for in a different way to anything £10,000 or under.

Paying tax on up to £10,000 in dividends

If you need to pay tax on up to £10,000 worth of dividends, you need to tell HMRC directly.

You can do so by:

  • calling the HMRC helpline
  • asking HMRC to change your tax code to incorporate the dividend tax
  • putting it in your Self Assessment tax return, if you already have to complete one.

You do not need to inform HMRC if your dividends are within the dividend allowance for that tax year.

Paying tax on over £10,000 in dividends

If you need to pay tax on dividends worth over £10,00 you need to fill in a Self Assessment tax return.

If you don't already complete a Self Assessment tax return, you need to register by the 5th of October in the tax year following the one in which you received the income.

The amount of dividends you receive from an investment is determined by how much you initially invested and the dividend yield of the company you invested in.

If you invested £100 into a business that has an annual dividend yield of 5%, you will receive £5 for every year of your investment.

However, the dividend yield of a company can change depending on how well both the company and the market as a whole are doing.

Generally speaking, the higher the dividend yield, the better the company is performing. But this isn't always the case. Some companies put up their dividend yield to attract new investors and then will reduce their yield once they have made more through investments. It is always good to search for companies that have a consistent level of dividend yields, rather than ones that fluctuate.

Dividend yields between 2% and 4% are generally considered strong. You should research anything higher than 6% to make sure that the company is stable and isn't simply trying to attract more investors.

Some of the most stable companies offer fairly low dividend yields but are consistent. With these companies, the rewards may not be huge, but you know that investing in them will lead to regular payments that are unlikely to change much over time.

Dividends are given to shareholders in companies. Shares are a single unit of a company's capital that has been equally divided.

We often hear about shareholders as they are company executives who earn millions or even billions of pounds through the shares they own in a big company. For example, the world's richest man, Elon Musk, will not be paid a penny in salary payments for the next ten years from his company Tesla. But the shares he owns are worth so much that he can maintain his billionaire status from the income they provide alone.

However, many normal people who are neither billionaires nor millionaires own shares in companies and use sensible and stable investments to provide them with additional income.

A recent survey revealed that around 2.2 million people in the UK own shares in one form or another.

The simplest way to buy shares is to do so on an online share dealing platform. Many of these platforms now also have mobile apps that mean you can make investments simply by using your phone.

You can also find a financial adviser who can guide you in making investments and buying shares or you can entrust them to make the investments for you.

There are also stocks and shares ISAs which are high-interest savings accounts that use your saved money to make investments. The yields that the investments deliver are then used to pay for the interest on your account. ISAs often have withdrawal terms that stipulate when and how much money you can take from them at any time.

Many people also choose to invest their money in premium bonds. Premium bonds are essentially shares that you buy from the government.

Premium bonds don't pay in dividends, instead, they pay in monthly cash prizes that are tax-free. The premium bond prizes range from £50 to £1,000,000.

Dividends are the financial distribution of a company's profits to its shareholders. They usually are paid in cash, but they can also be paid in further shares or assets.

Dividend tax is the tax you pay on any earnings you make from dividends above the tax-free allowance. The current tax-free allowance for dividends is £2,000. Dividend tax rates are determined by the Income Tax band you are in.

Many people buy stocks and shares in stable companies as a source of extra income. And while this is a common and generally safe practice, it is important to remember that no market is failproof and any investment can lead to a financial loss. So it is always wise to seek advice before investing in a company.