A friend of mine mentioned a whle back that the dividends the received from the pawnbroker Albemarle and Bond Hldg (LON:ABM) were now worth more than his entire initial investment. That is a classic example of something that Warren Buffett has called the "eighth wonder of the world" - the power of compound interest. At a 15% return per year, your annual return will exceed your initial stake in the 16th year and you'll have 'tenbagged' within 17 years. While there are a few stocks that may make an equivalent capital gain, the reality is that so few achieve it and investors often expose them to dreadful risks in seeking out this kind of speculative price move.
However, the flipside of the power of dividend reinvestment is the unfortunate drag caused by income taxes. As Frank Armstrong has observed, taxes are the natural enemy of investors! Unfortunately, the fact that dividends are taxed as income can have a big impact on reported returns from income investing. Historically, dividends have almost always been taxed less favourably than capital gains. According to research by Legg Mason Capital, in the US over the last 50 years dividends have been taxed on average at a rate of 50%. Meanwhile in the UK, dividends are taxed on a sliding scale according to your income band meaning that top-rate tax payers pay an awful lot more for dividend income than capital gains.
But it’s not all bad. You can prevent taxes from eroding your portfolio performance, as long as you remember to always buy them in a tax-efficient wrapper like an ISA or a SIPP in the UK. However, given that the whole tax situation is made so confusing, it's easy to mis-step. In this article, we'll try and get to grips with the dividend tax situation and make a few suggestions for maximising total returns.
In essence, dividend investment is basically subject to three forms of tax: stamp duty, capital gains tax and income tax:
1.Stamp Duty
This is a flat tax on buying all shares (but not unit trust shares shares as the trust pays it). If the transaction is paperless, the tax is called Stamp Duty Reserve Tax and you pay a rate of 0.5%. If you use a stock transfer form, then it's a paper transaction and you pay Stamp Duty on paper…
