Companies that offer generous dividends can be attractive to investors looking for income.
We look at dividends in more detail, the pros and cons, and whether you should reinvest dividends or cash out.
What is a dividend?
Dividends are payments to shareholders from the profits generated by a company.
They can either be paid as cash or in the form of reinvestment in additional company stock.
Usually, dividends are paid out per share every quarter, with the amount to be paid determined by the company.
It’s worth looking at the dividend yield of a company, which shows how much it pays out in dividends relative to its share price.
If, for example, the share price was £10 and the dividend amount was 50p, the dividend yield would be 5%.
The right yield can draw in investors, but what is seen as a good yield?
Usually, anything between about 2% and 5%. Below this, the shares won’t be as attractive, and too far above this, it could be riskier.
How do dividends work?
Dividends are usually paid by companies that generate a profit. Any proposed dividends need to be approved by the board of directors.
The company will announce any planned dividend payments, including the value by share, the date payment can be expected alongside other details.
When dividends are paid out, shareholders can either take the cash or reinvest them to buy more shares in the hopes of better returns.
They tend to grow in value over time, with many firms increasing the payout each year and can help lower portfolio risk and volatility.
Companies often use dividends as a way of pulling in funding.
The advantages and disadvantages of dividends
Dividends have many benefits as they generate passive income and allow shareholders to take advantage of compound interest via reinvestment, as well as offer tax benefits.
However, there are some downsides. It’s worth remembering that dividend income isn’t guaranteed as it’s tied to the success of a company.
While you have the dividend allowance, this was recently cut from £2,000 to £1,000 and this will be cut to £500 in the next tax year, further reducing the amount of dividend income that isn’t subject to tax.
Should you take cash or reinvest your dividends?
Cashing out your dividends may be worthwhile if you:
Want to diversify your portfolio and move into a different area of investment.
Are close to or at retirement age, and you need the income.
The company is continually underperforming, and you no longer want to be a shareholder.
If none of the above apply, you might wonder how to start reinvesting dividends.
You can set up an automatic dividend reinvestment plan (DRIP) with the company or broker, which may incur a fee.
Once your DRIP is set up, you can reinvest additional or fractional shares.
Purchases will generally be processed by the start of the next trading day.
Determining the best dividend-yielding investments
Your broader investment strategy and risk preferences will determine the best dividend-yielding investments for you.
It’s a good idea to do your research and perhaps contact a financial adviser who can recommend the best investment strategy for your needs and the right investment for you.
What do I need to pay in tax on dividends?
When you opt to take the cash, you’ll be taxed on your dividends.
The basic dividend tax rate is 8.75%, the higher rate is 33.75%, and the additional rate is 39.35%.
As previously mentioned, there’s also a tax-free dividend allowance of £1,000, which is set to reduce to £500 in April 2024.
You’ll only be taxed on dividend income that exceeds your dividend allowance.
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