By Alan Hardy
Head of Investments, Lloyds TSB Private Banking
From April 2004, the government will scrap the tax credit on dividends from shares held within an Individual Savings Account (ISA). A financial expert explains how the change will affect savers.
The end of the credit could dent bullish investors
How does the tax credit work?
Dividends on equity investments outside an ISA are currently taxed at 10% for basic rate taxpayers and 32.5% for higher rate taxpayers.
However, when held inside the ISA wrapper, they are tax free.
Over the past few years, when share prices have been on a roller-coaster ride, the tax credit has provided welcome solace for many investors.
By scrapping it the government will save an estimated £200m a year.
ISA changes: Key facts
Higher rate taxpayers still enjoy some tax advantages on dividends accrued within an ISA
Investments in an ISA retain Capital Gains Tax exemption
ISA investors looking for income may be hardest hit by abolition of the tax credit
Soon after Labour came to power in 1997, Chancellor Gordon Brown scrapped the tax credit on pension funds.
The financial problems that have beset many company pension schemes in recent years, have in part been blamed on the scrapping of the credit.
Who will be hardest hit?
Firstly, the millions of people who have cash ISAs have nothing to fear - the abolition of the tax credit makes no difference to them.
Many investors who buy shares with the idea of selling them later at a higher price may not feel much pain.
They may be using an ISA because any capital growth they receive from their investment is free from Capital Gains Tax (CGT).
Overall, it is investors who buy shares and funds which aim to provide an income that may well feel particularly hard done.
Shares and funds geared towards providing an income, through regular dividend payments, are particularly favoured by older investors as this best suits their risk profile and investment requirements.
What advantages are there in using an ISA?
Basic rate taxpayers currently pay no tax on any income from equity investments if they are held in an ISA.
When the tax credit disappears, basic rate taxpayers will pay 10% tax on equity income regardless of whether this is held inside or outside an ISA.
There would seem to be little incentive, other than as a shelter from Capital Gains Tax, for basic rate taxpayers to gather their equities under the ISA umbrella.
However, higher rate taxpayers still have an advantage.
Outside of an ISA, higher rate taxpayers would have to pay the full 32.5% tax on income.
Within an ISA, even after the scrapping of the tax credit, higher rate tax payers will only be taxed at a rate of 10% on all dividends.
So what strategy should investors adopt?
ISAs should still form an integral part of many people's portfolios but it may be worth investors, for whom income is critical, such as pensioners, reviewing their portfolio to ensure they are maximising the potential of their investments.
Overall, investors should not overreact to the ending of the tax credit nor should they let their view of ISAs be dominated by the loss of the tax credit.
The views expressed are solely those of Mr Hardy and are for general information only. They do not constitute financial advice as defined by the Financial Services and Markets Act and are not intended to be relied on for the purposes of making an investment decision. Always obtain independent advice from a qualified, registered financial adviser before making any investment decisions.