HOW TO LET FUNDS REAP DIVIDENDS ...WITHOUT FACING NEW TAX GRAB
USING an Individual Savings Account as a long-term investment bolthole will become more important in coming months. This is not just a result of continued poor savings rates making investments a compelling proposition. It is because of an imminent reduction in the tax-free dividend income that investors can earn from shares or investment funds held outside an Isa.
Currently, up to £5,000 of dividends can be received in the financial year ending April 5 without tax being applied. But in the new financial year, this tax-free allowance will reduce to £2,000.
For dividends above this limit, investors will be taxed at 7.5 per cent if they are basic rate taxpayers. For higher and additional rate taxpayers, the tax is 32.5 per cent and 38.1 per cent. In contrast, any dividends received within an Isa wrapper will remain free of these charges.
The impact should not be underestimated. Someone receiving £6,000 of dividends a year will pay £225, £975 or £1,143 extra in the new financial year – depending on whether they are a basic, higher or additional rate taxpayer.
Investors facing this tax crunch, can mitigate the effect by moving shares or funds into an Isa through a process called ‘bed and Isa’. The shares are sold, then bought back within the Isa. The investor’s annual £20,000 allowance is reduced by the cash equivalent of the sale of the shares. There will also be charges levied, typically on the repurchase of the shares within the Isa wrapper.
But if it stops tax eroding future dividend receipts, ‘bed and Isa’ will prove a wise move.
INCREASE INCOME
FOR those not in a position to ‘bed and Isa’, but who want to use spare cash to put money in an investment Isa in the current tax year or start of next, there are plenty of options available. Opposite, five leading Isa experts explain what they plan to do – if anything – between now and April 5 and what they have already done this tax year.
Among them, Jason Hollands of Tilney Investment Management will be using ‘bed and Isa’ to ensure some of his long-term savings are not hit by the reduction in the annual dividend tax allowance.
Many of the experts have chosen overseas funds (investing in the Far East and Latin America) as their selections for this tax year. But there remains a powerful case for picking shares or funds with an income bent, especially if the income – paid in the form of dividends – is automatically reinvested. This process is known as ‘accumulation’.
Research just released by fund management house Schroders shows the benefit of reinvesting dividends rather than taking them as income. If someone had invested £1,000 in the FTSE 100 Index at the end of 1999 – a few months before the dotcom crash of March 2000 – and pocketed the dividends, their lump sum would have grown by just 1.1 per cent annually over the next 18 years.
But if the dividends from the same leading companies had been reinvested, the annual return would be to a more impressive 4.6 per cent.
Nick Kirrage is a fund manager at Schroders. He says: ‘Dividend reinvestment is one of the most powerful investment tools available. As our research shows, the difference to the rate of return can be substantial. In an era where interest rates are so low, investors need to be aware of relatively simple investment techniques that can help build returns. Dividend reinvestment is one.’
Of course, investors must do their research and make sure the incomefriendly companies they are investing in can afford to keep paying dividends on a sustainable basis. The FTSE 100 stocks currently paying the highest dividends include oil giant BP, which yields 6.3 per cent, as well as Vodafone and tobacco firm Imperial Brands, which yield 6.5 per cent and 7 per cent respectively. Other top payers include pharmaceutical firm GlaxoSmithKline, mining giant Rio Tinto and insurance company Phoenix Group. Telecoms giant Vodafone, for example, has increased its dividends for 28 years running, while energy supplier SSE has raised its dividend for 26 consecutive years.
Adrian Lowcock is investment director at fund manager Architas. He says: ‘Securing an income is not as straightforward as just looking for companies with the highest yield. Investors should consider whether the payout is sustainable, what the outlook for the business is and how likely it is to grow its dividend.’
Some 26 firms in the FTSE 100 have increased their dividend every year for the past decade – no mean feat when you consider that includes the
2008 financial crisis. But picking top dividend-payers yourself can still be tricky. An alternative is to invest in a UK or global income fund that has a portfolio comprising dividend-friendly companies.
Lowcock likes Artemis Income, which invests in FTSE firms such as BP, Vodafone and Lloyds Bank. The fund has returned 48 per cent over the past five years and yields 3.9 per cent.
He also recommends the Schroder UK Alpha Income fund, which invests in Vodafone, GlaxoSmithKline and Rio Tinto, among others. The fund has returned 36 per cent over the past five years and raised its dividend in eight of the past ten years. It yields almost 5 per cent.
Finally, Lowcock tips Fidelity Moneybuilder Dividend, which has returned 32 per cent over the past five years and yields 5 per cent. It holds big consumer-oriented firms such as Unilever, which makes Persil, and Imperial Brands.
All of Lowcock’s selections are income funds. Income-oriented investment trusts are also worthy of inclusion in an Isa because of their ability to smooth the dividends paid to shareholders.
According to the Association of Investment Companies, there are 21 investment trusts that have increased their dividends for more than 20 consecutive years. They include both global (Alliance, Foreign & Colonial and The Bankers) and UK invested trusts (JPMorgan Claverhouse, Murray Income and The City of London). A full list is available at theaic.co.uk.