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If you are interested in investing in the stock market, then you might have heard of dividend investing. Yet how is it different from other types of equity investment, and how should it fit within an investment portfolio?
In this short guide for 2020, our Lancashire-based financial planning team will be sharing some thoughts on these sorts of questions. We hope you find this content helpful. If you’d like to speak to an independent financial adviser about your financial plan, you can reach us via:
T: 01282 772938
What are dividends?
When a company makes a profit, it often distributes some/most of those profits to shareholders, which is called a dividend. Most often these dividends take the form of cash payments, and they might be paid once a month, once a quarter or some other frequency.
Newer, faster-growing companies might choose to reinvest their profits into the business rather than focus on paying dividends, to fuel further growth. More established companies, however, are often more ready to distribute profits to shareholders.
Dividends are usually distributed to shareholders according to the percentage of stock they hold in a business. If, for instance, you own 30% of the company shares, then you should expect to receive 30% of any dividends issued.
Why consider dividends?
Dividend investing does have its drawbacks, but it is also fair to say there are attractive benefits too. One attractive feature of dividends is its ability to generate passive income for investors. Suppose your stocks in an index such as the FTE 100 yield 3-5%; this could enable someone to generate quite a large source of income just from dividends. These dividends can then be used to help support the investor’s lifestyle or be used to reinvest into the portfolio – fuelling growth.
Another reason to consider dividends lies in their potential to generate long-term returns. One study in 2016, for instance, suggested that the FTSE 100 returned about 15% over ten years when dividends were excluded. However, when they were featured within the calculation the figure rose significantly to total returns of 67%.
One final reason given in favour of dividend investing concerns falling markets. During a bear market, dividend-paying companies tend to be those which are more established, featuring impressive track records. The argument, therefore, is that these company stocks usually fall less during down markets compared with other stocks. However, this is not always the case.
What are the downsides of dividends?
One disadvantage of dividend stocks often noted by our Lancashire financial advisers is the potential cap on returns. It’s worth noting, for instance, that even the highest-yielding stocks do not often pay out more than 10% per quarter. On the other hand, a stock strategy which focuses on growth might suffer greater losses in the short term, but the potential return over the long term could be much higher.
Dividends from a company can also go down over time as its business strategy evolves. It is also quite difficult to identify stocks which have a high likelihood of high future dividend yields.
How does tax on dividends work?
Companies which issue dividends do not usually pay taxes on them, but shareholders receiving them might have to. In 2020-21, however, the good news is that you can receive up to £2,000 in dividend income before it is liable to tax (i.e. your Dividend Allowance). This is in addition to the personal allowance £12,500 in this same tax year.
Once your dividend income exceeds £2,000 within the financial year, however, then you are likely to pay tax according to your highest Income Tax bracket. Basic Rate taxpayers, for example, will likely pay 7.5% on their dividend income over their allowance, whilst for those on the Higher Rate, it is 32.5% (Additional Rate taxpayers will face 38.1% tax).
One important caveat to all of this noted by our Lancashire financial advisers concerns ISAs (individual savings accounts). In 2020-21, you are allowed to save up to £20,000 within your ISA(s) and any interest, capital gains or dividends earned will not be subject to tax. This can make ISAs an attractive tool for investors looking to mitigate their dividend tax bill, by relocating some of their dividend investments in this tax-efficient “wrapper”.
Conclusion & invitation
Dividends hold lots of appeal for particular investors, particularly those who like the idea of having an additional “passive” income stream. Our Lancashire financial advisers also recognise that there is a psychological appeal to the idea of receiving regular payments into a bank account, especially from a prestigious or recognised brand name.
However, there are important disadvantages to dividend investing which are important to consider with your financial adviser, in light of your financial goals and investment strategy. In particular, a long-term investment strategy will want to take particular note of the growth potential of “dividend-paying” stocks, compared to “growth-focused” stocks.
If you are interested in starting a conversation about your financial plan, then we’d love to hear from you. Please contact us to arrange a free, no-commitment consultation with a member of our team here at Elmfield Financial Planning in Padiham, Burnley, Lancashire. Reach us via:
T: 01282 772938
