What tax do I pay on savings and dividend income?

Updated on 8 September 2019

Pensioners

Savings and dividend income can come from a number of different sources. This page explains those sources and what tax you have to pay on them.

What is savings and dividend income?

Savings income includes interest from:

  • banks;
  • building societies;
  • National Savings and Investments (NS&I) accounts.

Savings income also includes income such as purchased life annuity payments and gains from life assurance contracts, as well as the interest element of PPI pay-outs.

Technically, savings income does not include dividend income, such as dividends or distributions from:

  • company shares;
  • unit trusts;
  • open ended investment companies.

Dividend income is subject to different rates and allowances.

However, the term ‘savings income’ is sometimes used to include dividend income. It is also used interchangeably with ‘investment income’.

Savings income also does not include property income. Income from letting out a property – also known as rental income – is non-savings income and taxed as such.

You can find out whether or not your savings and dividend income is taxable by looking at the tax basics section.

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What tax do I pay on bank and building society interest?

There is more information on how bank and building society interest is taxed in our section on savings and tax.

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What tax do I pay on my purchased life annuity?

Purchased life annuities are financial products purchased with a capital sum. They are designed to provide a guaranteed annual sum – normally for life, but it could be for a shorter term. That annual sum comprises two separate elements:

  • a capital element – which is a return of part of the original capital used to purchase the annuity – that is free from tax; and

  • an element of income. This income element is treated as savings income and is paid net of basic rate tax (20%).

Each year you will receive a statement showing the total sum paid to you. This will comprise the capital amount (non-taxable) and the income amount (taxable) less the tax deducted.

The final amount of tax due on your income from a purchased annuity will depend on your situation and whether or not the income falls within the starting rate for savings and the personal savings allowance (otherwise known as the savings nil rate). Our savings and tax section explains more.

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What tax do I pay on gains from life insurance policies or investment bonds?

If you take out an insurance policy or investment bond, the profits you make on the policy or investment bond when you cash it in might be taxable. You should ask a financial adviser or a specialist tax adviser for more information. We tell you how you can find a tax adviser in our Getting Help section. This guidance covers those policies where the profits, which are often called 'gains', are taxable.

Regular income

Each year you can withdraw, tax free, up to 5% of the amount you originally invested. If you do not withdraw 5% in one year you can carry it forward. For example, if you have previously taken nothing out of the policy, in year three you could take 15% (3 x 5%). 

Any amounts you withdraw as an income will be taken into account when you cash in the policy and will make the end profit higher, so it is worth remembering this if you do not need to take out the money each year.

Example – Mr Chang

Mr Chang purchases an investment bond for £10,000. He takes annual withdrawals of 5% each year for six years, totalling £3,000. There is no tax on the withdrawals at the time he makes them. Several years later he cashes in the bond for £11,800. However, the profit liable to tax is not £1,800 but £4,800 – because the £3,000 withdrawals are added into the gain calculation made when his policy ends.

If Mr Chang exceeded the 5% rule in one of the six tax years by taking out £1,000 instead of £500, then this ‘excess withdrawal’ of £500 would have been treated as taxable income on him for the year in question. If Mr Chang’s bond was an onshore bond, the £500 excess withdrawal would have carried a 20% un-reclaimable tax credit, meaning he would only have had to pay tax on it if he was a higher or additional rate taxpayer. There would have been no such credit for an offshore bond.

Part surrender

If you take more than 5% out (or the percentage you are allowed to take out, if you have 5% amounts brought forward from earlier years), you may trigger a taxable gain on the excess – even if the policy has not made a gain on its original investment or has made a loss.

If the gain triggered appears to be excessive compared to the value of the investment and the amount cashed in, you should ask HMRC to recalculate the gain on a ‘just and reasonable’ basis. This ability to ask for a recalculation became law from 6 April 2017. For gains triggered before that date, HMRC should in any case be prepared to consider a recalculation of the gain following principles set through cases taken to the Tax Tribunal. See GOV.UK for the case of Joost Lobler v HMRC [2015] UKUT 0152 (TCC).

Cashing in the policy

You make a profit or gain on the policy if the amount you get when you cash it in is more than the amount of the premiums you have paid.

When you cash in the policy, any profit you make is free of capital gains tax. You can think of it instead as an 'income tax gain'. This is not the same type of gain that you make when you sell or give away an asset.

If you pay tax at the starting rate for savings, savings nil rate (personal savings allowance) or are a 20% basic rate taxpayer, you have no more tax to pay on the profit or gain you make. This is because the profit that you make on the policy is treated as having already suffered tax at 20%. Offshore bonds do not carry the 20% ‘credit’.

Please note that it is not possible to get any of this tax back, even though the personal savings allowance (PSA) will see greater numbers of policyholders with no tax to pay on life insurance gains. This is because the 20% deduction does not equate to a ‘withholding tax’ per se. Rather, the arrangements reflect the unique regime applying to life insurance companies, under which part of the corporation tax paid is regarded as relating to investment gains made in the company for the benefit of policyholders. The rules implementing the PSA will, however, ensure that the allowance is applied to other types of savings income before life insurance gains. This will minimise situations in which no repayment is available in respect of non-taxable gains treated as taxed at the basic rate.

If you are a higher rate (40% in 2019/20) or additional rate (45% in 2019/20) taxpayer, you will have to pay extra tax. The profit on the policy is treated as the very top slice of your income. If you are a higher rate taxpayer, you will pay tax at 40% less the 20% tax that you are treated as having already paid.

Example – Tom

Tom is a 40% taxpayer. His taxable income for 2019/20 is £52,000. He also makes two gains on life insurance policies he cashed in during the year. The Profitable Insurance Company has sent certificates to Tom showing what profits he made.

The gains amounted to £10,000 on each policy so Tom will need to pay extra tax of £4,000, worked out as £20,000 @ 20% (40%-20%).

If the profit pushes a basic rate taxpayer into higher rate or higher rate taxpayer into the additional rate, there is a special relief available, called 'top slicing relief'. Top slicing relief may assist in reducing the amount of tax charged by applying a spreading mechanism. This recognises the fact that although the gains have probably arisen over the period of investment they are assessed in a single year which can cause disproportionately higher liability.

Consider, for example, someone who invested £10,000 in a bond and left it for 10 years, during which time it doubled in value. If the entire profit of £10,000 was assessed in a single year, it might attract a higher amount of tax than if the returns were assessed annually. With top slicing relief applied, the gain of £10,000 would be divided by the number of complete years the bond had been held, in this case 10, creating an average gain of £1,000. The top sliced gain is added to the investor’s taxable income in the year the bond is cashed in and the amount of tax due on the top sliced gain is calculated. This is then multiplied by the number of years the bond was held to find the tax due on the total gain. So, top slicing relief has the effect of calculating any tax that may be payable at the investor’s marginal rate of tax on the average annual gain.

HMRC’s helpsheet 320 helps explain this further, however you should contact HMRC if you think this is likely to apply to you.

You need to show the profits on your tax return if you need to complete one and you will receive details of the amount to be included from your insurance company. This is called a chargeable event gain certificate. If you do not receive a certificate you should contact the company and ask for one.

You should bear in mind that any life insurance profits count as your income when working out what married couple's allowance you may be entitled to. Even though you may still be a basic-rate taxpayer, the loss of married couple's allowance means you will effectively be paying more tax. You can see more about married couple's allowance restrictions in the pensioners section.

Policy pays out on death

If the policy pays out on your death, your estate will only pay tax on the difference between the surrender value and the premiums you paid, even where the total benefits paid out from the policy are more than the surrender value. This is so that you are only taxed on the profit you make from the investment up to the date of your death and not on any life insurance element. This is called the ‘mortality profit’.

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What tax do I pay on dividends?

Our guide to tax on dividends can be found in our other tax issues section.

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Where can I find more information?

You can find more information on the taxation of savings income in our savings and tax section.

If you want to claim tax back, in the first instance, look at our tax basics section.

We also have information to assist you in working out what tax rate applies to you.

You can read more about top slicing relief in HMRC’s technical Insurance Policy Holder Manual.

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