I will continue to invest regularly in dividend stocks inside a Stocks and Shares ISA in 2021

Investing in dividend stocks within the tax-free wrapper provided by a Stocks and Shares ISA can lead to impressively compounded returns.

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The core of my Stocks and Shares ISA is made up of dividend hero stocks. I drip money into the core of my portfolio each month. Let me explain why regular investing in dividend-paying stocks inside a tax-free wrapper (provided by a Stocks and Shares ISA) is a cornerstone of my investment plan.

Regular investing

2020 was a challenging year for investors. Stock markets around the world crashed in March. The FTSE 100 fell around 30% in little under a month to a low of 5,191. Then it rallied into June and drifted downwards into November. From December 2020 into 2021, the FTSE 100 has been moving higher but in a volatile fashion. Down at the level of individual stocks, there was much more variability in returns.

No matter the nature of the crisis, the timing and magnitude of the stock market response is difficult to predict. Often the crisis itself is unexpected. Market volatility is inevitable. That leads to an unsettling conclusion: I will invest just before markets fall, and miss out on price rises.

I have accepted this, and as a response, I regularly invest each month no matter what the market is doing or what I think it will do. Over time I will invest at relatively high prices, but also relatively low ones. I will invest before declines, but also near the start of recoveries. I aim for average performance, which is hopefully also positive.

Dividend hero stocks

The core of my Stocks and Shares ISA portfolio is composed of dividend hero stocks. These are typically FTSE 100 companies that have not cut their dividends within the last 10 years. A company can stop paying dividends at any time. But a long track record like this suggests that the company recognises the value of dividends to shareholders and has managed itself accordingly.

Dividend hero stocks are usually in non-cyclical sectors of the economy; think of branded consumer goods or pharmaceutical companies. Having relatively less variability in revenue and, therefore earnings, tends to make paying dividends regularly easier.

I am looking for regular dividend payments because I want to use them to buy more stocks. More stocks should translate to larger dividend payments which can buy even more stocks. There are no guarantees in stock investing, but I am hoping to benefit from compound growth through dividend reinvestment in the core of my Stocks and Shares ISA portfolio. 

Tax-free Stocks and Shares ISA

Dividends are normally taxed annually. This can produce significant drag on reinvestment return. If a stock has a 4% dividend yield, over 10 years, a £100 investment would be expected to grow to £148 with dividend reinvestment without taxes. However, with annual taxes of 20%, the investment would be worth £137. Taxation has consumed £11, or around 23%, of the potential gains. The fact that the percentage of consumption is higher than the tax rate suggests that the tax drag compounds over time.

Indeed the tax drag does get worse over time, with higher yields, and, obviously tax rates. That’s why I regularly invest in dividend-paying stocks within the tax-free wrapper provided by a Stocks and Shares ISA. Otherwise, taxation will gobble up a large chunk of any gains.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

James J. McCombie has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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