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:
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 transactions at the same 0.5% rate, rounded up to the nearest £5 (but there is no tax to pay if you spend £1,000 or less on the shares). Frankly, this is an arbitrary tax on investing that most sensible commentators think should be repealed but, unfortunately, this looks unlikely to happen any time soon for political reasons.
Of course, stamp duty is not applicable if you're spreadbetting and, while you might assume that dividends are not payable when spreadbetting, in fact they are. With daily rolling contracts, you should receive a credit to reflect dividends paid on shares and other corporate actions like rights issues, scrips and stock bonuses are also paid too. However, it's important to calculate the interest charges built into the spread and compare this cost vs. the stamp duty you're saving out on. While spreadbetting may be attractive over the short-term, it's likely to be far less attractive for long-term "buy and reinvest" dividend income investors.
2. Capital gains and capital gains tax (CGT)
A capital gain is made if you sell a dividend stock for more than you paid for it. Each tax year you have a capital gains tax (CGT) allowance which is known as the annual exempt amount. This is the amount of profit you can make from disposing of assets in that tax year without having to pay any CGT. Any profits above this amount are taxed. The profit is added to your taxable income for the year and any part of the profit falling within your basic-rate band is taxed at 18%, anything more at 28%. However, some investments are exempt from CGT such as gilts, most corporate bonds and stocks & shares ISAs. It's important to keep track of off-setting capital losses but remember - you can't use losses on ISA investments to reduce Capital Gains Tax on profits from investments outside the ISA.
3. UK Dividend Income Tax
If you have ever been a shareholder in a UK company, it's likely that at some time you've received a dividend cheque in the post and the joy that comes with knowing that this is income that you haven't actually had to earn. But you also receive with your cheque a tax voucher that shows the amount of the dividend you've received from your shareholding and an additional tax credit line. These both add up to your gross dividend income and generally create a bunch of confusion.
Double Trouble: What is this tax-credit anyway?
Dividends are paid out of a company's net (after tax) profits. But dividends are treated as income by the taxman, and as a result are liable to be taxed at the prevailing rate of income tax. This effectively leads to a form of 'double taxation' whereby if a company paid out all its profit as dividends, the cash received by the investor would be taxed twice - first by corporation tax, secondly as income tax. This double taxation though is a real headwind for investors to sail against, so some countries provide a limited tax-credit on dividends.
Since 6th April 1999, all UK company dividends have carried a tax credit of 10%. The tax credit applies to all dividends regardless of whether the shares are held directly or in a fund such as a unit trust, OEIC or investment trust. The 10% tax credit can be set against your tax liability, but your ability to "use" that tax credit depends on whether you are a nontaxpayer, a basic rate taxpayer or a higher rate taxpayer. This effectively means that basic rate taxpayers get their dividends taxfree, while still hitting the higher tax payers at an effective rate of 25% or 36.1% depending on the tax band.
How It Works
At the basic level this works a bit like PAYE. The dividend issuing company is deemed to be paying the basic rate of income tax (10%) for you at source on your gross dividend income, before sending you your post tax dividend cheque. Once this whole shenanigan has been applied, the dividend you actually get in the cheque is the actual dividend advertised by the company. Phew.
First up, it's worth being clear on the difference between the tax rates on dividend income and other forms of income:
|Earnings Above Allowance||Income Rate||Div. Income Rate|
|More than £34,370||40.0%||32.5%|
In reality, the tax credit system means that investors earning a total annual taxable income below £34,370 are required to pay no tax whatsoever on their dividend income. This is because, for these individuals, dividend income is taxed directly at source at a rate of 10%.
If, on the other hand, your total annual taxable income is above £34,370 but less than £150,000 you will be required to pay dividend tax at a rate of 32.5%. However, the 10% tax credit mitigates your liability, bringing the 'real' rate down to 25%. Similarly if you pay a total of 42.5% tax on dividend income that exceeds the higher rate Income Tax limit of over £150,000, the effective rate owed on the dividend income would be 36.1%
Please note that dividends with REIT structures known as PIIDs are a thing unto themselves, as discussed here.
Non-tax payers lose out
If your total income (including dividend income) is below the annual £8,105 allowance (i.e. you are not a taxpayer), you don't have to pay any more tax on the dividend, but unfortunately you cannot recover the tax you've already paid (or which you are credited as having paid). In effect the 10% is lost.
Basic rate tax payers effectively pay 0% tax on dividends
So if you are a basic rate taxpayer (< £34,370 income above your £8,105 base allowance) you end up paying no tax at all on your dividend as your income tax liability is exactly equal to the tax-credit issued and paid for you by the company (10%!). If you receive a £90 dividend cheque the company has actually issued you with a tax-credit adjusted £100 gross dividend but paid the £10 in tax for you. As a result basic rate taxpayers then don't need to worry about whether dividends are received in an ISA or not, as effectively they are paying no tax on dividends anyway.
Higher rate tax payers effectively pay 25% tax on dividends
Higher rate tax payers (> £34,370 but < £150k income above your base allowance) pay 32.5% tax on gross dividends, but as they've already paid 10% before receiving their net dividend cheque the effective additional tax they have to pay becomes 25%. An example helps - imagine you receive a gross dividend of £1111 (i.e. a dividend cheque of £1000 + a £111 tax credit). That £1111 is taxed at 32.5% to leave you with £750 net after alltaxes -so on top of the £111 tax paid at source, you effectively have to pay an additional £250 (25%) on top Unfortunately tax payers in this band *are* suffering from the aforementioned dreaded double taxation.
Additional rate tax payers effectively pay 36.1% on dividends
Additional rate tax payers ( > £150k income above the base allowance) pay 42.5% tax on dividends, but as they've already received the 10% tax credit effectively the rate becomes 36.1%. e.g. imagine you receive a gross dividend of £1111 (dividend cheque of £1000 + a £111 tax credit as in the example above). In this case the £1111 received is taxed at 42.5% to leave you with £638.88 net - i.e. you effectively have to pay an additional 36.1% on your dividend cheque received or just over £361.
Why dividend income taxes are such a drag
Considering that capital gains tax is taxed at a lower 20% rate, paying 25% or 36.1% for dividend income acts as a real drag on your potential returns. Furthermore, the unfortunate reality of income taxes is that they have to be paid more or less immediately. Capital gains taxes can be deferred until they are realised which means they essentially become an interest free loan - providing leverage in your portfolio that can compound growth rates. Berkshire Hathaway's Charlie Munger illustrates this point with the example of an investment offering a 10 percent annual return which pays taxes every single year against one that pays all taxes in a lump sum at the end:
“You add nearly 2 percent of after-tax return per annum from common stock investments in companies with tiny dividend payout ratios.”
This is not to be sniffed at! As Aswath Damadoran notes in his book “Investment Fables”, if you actually factor in the drag that these high income taxes have on dividend stock strategies, many actually massively underperform the market!
As mentioned, you can still benefit from the reported outperformance of dividend stocks as long as you always buy them in a tax-efficient wrapper like an ISA, a Child Trust Fund or a SIPP. With these investment accounts, taxes are either waived or deferred allowing dividend income to accrue and allowing it to be reinvested at the full face amount. The higher your income tax bracket, the more important it is to do this. One of the biggest mistakes an investor can make is to forget this.
Any gains from investments in an ISA are tax-free and income is also tax-free although you cannot reclaim the tax credit paid on dividends. Contributions into a pension scheme attract income tax relief. Also, when you sell the investments to buy an income in retirement, part of this money can be taken as a tax-free lump sum.
If you are an ambitious shareholder - and presumably by using Stockopedia, you are - you'll be planning on reinvesting dividends and growing your pot over time. While basic rate taxpayers may think that it doesn't matter whether they buy dividend paying stocks in a tax-free wrapper or not (as they effectively pay 0% dividend tax) the truth is that if they reinvest their dividends consistently their shareholdings will grow to the point where their dividend income will tip them over to the higher rate tax band. At this point they'll suffer from double taxation and dearly wish they had bought them elsewhere. Given this it might be wise to always buy dividend paying stocks in a tax-free wrapper!