Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
What are dividends and why do they matter?
When you buy a share in a company you are literally buying a share in its future earnings. As an ordinary shareholder, you are entitled to vote at the company’s annual general meeting and any extraordinary meetings that are called, to buy more shares when the company has a pre-emptive rights issue, and most importantly you own a share of the dividends.
Dividends are cash payments to shareholders from the company’s earnings after accounting for operating costs, interest costs, taxes and essential investment in the business.
Dividend payments are not guaranteed, and some companies pay no dividends at all. Some can’t afford to pay them; others prefer to keep spare cash to help grow their business. For those who do pay dividends, each company has the discretion to pay as much or as little as it likes.
HOW OFTEN ARE DIVIDENDS PAID?
Companies tend to pay dividends half-yearly, or some quarterly, as a way of compensating shareholders for the risk of holding their shares. After all, you could invest in government bonds and get a guaranteed income instead.
Most of the time, as long as companies are growing their earnings per share, shareholders can look forward to a steadily rising stream of dividends year after year.
Some shareholders will want to reinvest their dividends in the company and allow their holding to compound, while others will want to take the cash to pay some of their outgoings.
The latter is typical of people who are retired and don’t want to eat into their capital, so they collect their regular dividend cheques and use them to pay some of their bills.
As well as ordinary shares, some companies issue preference shares. Unlike ordinary shares, preference shares come with no voting rights, but they pay a fixed rate of interest, similar to a bond. Also, the owners of preference shares receive their dividends before holders of the ordinary shares.
PROS AND CONS OF DIVIDENDS
There are differing views among investors on the importance of dividends as a source of income. Terry Smith, the founder of asset manager Fundsmith, prefers companies he invests in to plough as much of their retained earnings back into the business as possible to keep generating high returns. When he wants to raise cash, he simply sells a small number of shares from different holdings instead.
Berkshire Hathaway – the investment company run by famous investors Warren Buffett and Charlie Munger – hasn’t paid a dividend since it was founded. Instead, it has looked for attractive investment opportunities and, failing that, it has bought its own shares back as a way of enhancing shareholder returns.
The drawback with taking income in the form of dividends is there is a tax on payments over the personal allowance, which is currently £2,000. To work out your tax band, add your total dividend income to your other income. You may pay tax at more than one rate.
A WORKING EXAMPLE
You get £3,000 in dividends and earn £29,570 in wages in the 2021 to 2022 tax year.
This gives you a total income of £32,570.
You have a personal allowance of £12,570, which is the amount of income you do not have to pay tax on. Take this off your total income to leave a taxable income of £20,000.
This is in the basic rate tax band, so you would pay:
– 20% tax on £17,000 of wages;
– no tax on £2,000 of dividends, because of the dividend allowance;
– 7.5% tax on £1,000 of dividends.
For higher rate taxpayers the rate is 32.5% on dividend income over £2,000, and for additional rate taxpayers the rate is 38.1%.
If you regularly receive more than the personal allowance of £2,000 in dividends, the advice is to contact HMRC and ask to have your tax code changed so that tax is withheld at source from your salary or pension.
If the shares are held in a tax-efficient wrapper, such as an ISA, Junior ISA or SIPP, there is no UK income tax to pay on the dividends.
WATCH OUT FOR OVERSEAS-DOMICILED COMPANIES
Several UK-listed companies are domiciled in other countries for tax reasons, which has different tax implications. For example, mining firm Ferrexpo (FXPO) is domiciled in Switzerland and pays dividends in US dollars, although UK investors can opt to receive payment in sterling. Either way, a Swiss withholding tax of 35% applies on dividends and is deducted at source.
Confusingly, rival miner Glencore (GLEN), which is also based in Switzerland and pays dividends in dollars, euros, sterling and South African rand, has got around the withholding tax by treating distributions as a reduction of the company’s ‘capital contribution reserves’.
A STABILISING INFLUENCE
Dividends are an important part of the UK retail investor landscape and the strength of demand can be shown by the size of the equity income sector of the UK’s investment trust industry.
According to the Association of Investment Companies, there is almost £19 billion allocated to income funds, with £12 billion invested in UK-specific trusts alone.
These include Finsbury Growth & Income [FGT), managed by Lindsell Train, and City of London (CTY), managed by Janus Henderson, with each accounting for over £1.7 billion of assets.
Moreover, as Simon Gergel, manager of The Merchants Trust (MRCH) points out, in the last 20 years dividends have played a crucial role in stabilising the returns on UK stocks.
In the period from 1975 to 2000, share price gains were far and away the biggest contributor to total returns. However, since 2000, in each of the four five-year periods to 2020, dividends have contributed most of the overall returns investors have enjoyed in UK stocks.
Disclaimer: The author owns shares in Finsbury Growth & Income.