From time to time, Morningstar publishes articles from third party contributors under our "Perspectives" banner. Below, portfolio manager Ian Lance fromRWC Equity Income Funds discusses the main misconceptions surrounding dividend investing.
There are two common misconceptions about dividend investing that can lead investors to overlook dividend-paying stocks and funds. Read on to ensure you do not allow these misconceptions to confuse your investment strategy and lead you astray.
1. “I don’t really need income right now so I am better off investing for capital growth”
This is a statement that I have even heard from professional financial advisers and is often linked with “I am young and have a long time until retirement, therefore I am going to invest in growth stocks now and will leave it until I am approaching retirement to switch into boring dividend stocks”.
We believe that investors should focus on total returns and that dividends have an important part to play within this. The fact is that dividend strategies produce better total returns than the market and thus even if your long term goal is to build wealth rather than generate income, dividend strategies are a natural way to invest. Figure 1 below illustrates this point.
What will surprise many investors is that high dividend payout stocks also have higher rates of earnings growth as documented in a paper from Rob Arnott ‘Surprise! Higher dividends=Higher earnings growth’.
As Figure 2 below demonstrates, stocks with high and growing dividends tend to have good total returns and lower volatility thus generating very attractive risk-adjusted returns.
2. “Dividends are taxed at a higher rate so I am better off focusing on capital gains”
Now we are not tax advisors and would always suggest that investors take individual tax advice but this seems to be one of those classic situations where the sweeping generalization is wrong.
The table below comes from the HMRC website and shows various tax rates on dividends.
What is important to remember, however is that companies pay you dividends out of profits on which they have already paid - or are due to pay - tax. The ‘tax credit’ takes account of this and is available to the shareholder to offset against any income tax that may be due on their dividend income.
When adding up your overall taxable income you need to include the sum of the dividend(s) received and the tax credit(s). This income is called your dividend income.
Let's say you receive a cash dividend of £900. This is the net amount received.
The tax credit is £100 (£900 * 1/9) meaning that the gross value of the dividend is £1,000.
Here's how the additional tax liability can be worked out:
- Basic rate taxpayer = £1000 x 10% = £100 less tax credit = £0
- Higher rate taxpayer = £1000 x 32.5% = £325 less tax credit = £225
- Additional rate taxpayer = £1000 x 42.5% = £425 less tax credit = £325
Capital gains allowance is currently set at £10,600 meaning you pay no tax until you go above that threshold. But as we can see in the above example, a basic rate taxpayer also pays no tax on dividends until their total income goes through £34,370.
Capital gains will also depend on your level of income as specified on the HMRC website. Individuals can be taxed at a rate of 18% or 28%, depending on the total amount of their taxable income.
So whilst a top rate tax payer pays a higher income tax rate on dividends (42.5%) than even the top rate of capital gains tax (28%), it is not correct to say that this applies to all taxpayers.
There are also other potential disadvantages to selling shares over taking income. The most significant is timing (i.e. the moment you need to raise income by selling shares could coincide with a low point in the market.) Meanwhile, dividends tend to be stable throughout the market cycle.
We believe that these misconceptions cause some investors to overlook dividend strategies and miss out on their benefits. In our opinion, they deserve a place in most investor’s portfolios.
This article was provided by Ian Lance, a portfolio manager fromRWC Equity Income Funds. The views contained herein are those of the author(s) and not necessarily those of Morningstar.
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