Background
The rate at which dividend income is taxed depends on the income tax band it falls within. However, the rate payable is set at a different, lower rate to earned income.
In addition, there is a tax-free dividend allowance, which means no tax is payable on the first £500 of dividend income. This is available to all taxpayers, regardless of whether they pay tax at the basic, higher or additional rate.
For 2025/26 the tax rates for earned and dividend income are as follows:
| Earned income* | Dividend income | |
| Personal allowance | £12,570 | |
| Dividend allowance | £500 | |
| Basic rate | 20% | 8.75% |
| Higher rate | 40% | 33.75% |
| Additional rate | 45% | 39.35% |
*for England, Wales and NI, rates in Scotland differ.
Opportunity
Whereas the tax difference between basic rate (20%) earnings and higher rate (40%) earnings is 20%, the tax difference between basic rate (8.75%) dividends and higher rate (33.75%) dividends is 25%. This means there is an opportunity to make greater tax savings via pension contributions.
Dividends don’t count as relevant UK earnings for the purpose of attracting tax relief on pension contributions. However, there can still be savings to be made.
Example – Jack
Jack lives in England and earns £49,770 a year. He will receive a further £10,500 this year in dividend income from some investments he holds. His total income for 2025/26 is therefore £60,270 which is taxed as follows:
| Earned income | Dividend income | |||||
| Amount | Tax % | Tax £ | Amount | Tax % | Tax £ | |
| Personal allowance | £12,570 | 0% | £0 | £0 | 0% | £0 |
| Dividend allowance | £0 | 0% | £0 | £500 | 0% | £0 |
| Basic rate tax* | £7,200 | 20% | £7,440 | £0 | 8.75% | £0 |
| Higher rate tax | £0 | 40% | £0 | £10,000 | 33.75% | £3,375 |
| Total | £49,770 | £7,440 | £10,500 | £3,375 | ||
* Basic rate tax band is effectively reduced by £500 as dividend allowance sits within this.
Jack’s tax bill is therefore £10,815 (£7,440 + £3,375) leaving him with net income of £49,455 (£60,270 - £7,440 - £3,375).
Jack’s adviser suggests making a pension contribution of £8,000 to a relief at source scheme, grossed up to £10,000 (£8,000 / 0.8) after basic rate tax relief is added. Higher rate relief is then given by extending his basic rate band by the gross amount of the contribution (i.e. £10,000). His tax liability is now as follows:
| Earned income | Dividend income | |||||
| Amount | Tax % | Tax £ | Amount | Tax % | Tax £ | |
| Personal allowance | £12,570 | 0% | £0 | £0 | 0% | £0 |
| Dividend allowance | £0 | 0% | £0 | £500 | 0% | £0 |
| Basic rate tax* | £37,200 | 20% | £7,440 | £10,000 | 8.75% | £875 |
| Higher rate tax | £0 | 40% | £0 | £0 | 33.75% | £0 |
| Total | £49,770 | £7,440 | £10,500 | £875 | ||
* Basic rate tax band is effectively reduced by £500 as dividend allowance sits within this.
Doing this means Jack’s tax bill is reduced to £8,315 (£7,440 + £875). Taking into account the pension contribution, this leaves him with a net income of £43,955 (£60,270 - £8,315 - £8,000).
The pension contribution of £10,000 has cost Jack £5,500 (£49,455 - £43,955). This equates to an effective tax relief of 45% (£5,500 / 0.55).
Comment
Even though Jack’s highest rate of tax was the 33.75% he paid on dividends, the pension contribution attracted 45% tax relief. A very useful saving for people earning a high dividend income from shares that are held outside a pension or ISA wrapper.