Many people start investing because of the lure of passive income. This is understandable, as enough dividends flowing into an investing account may make it possible to escape the rat race and travel the world.
So, rather than a boss breathing down your neck, you could instead be enjoying a cool ocean breeze on a Bali beach. It sounds wonderful, and lots of people have achieved it well before retirement age.
However, without wanting to rain on anyone’s passive income dream parade, it’s vital to keep three things in mind when it comes to dividend investing.
Watch out for yield traps
The first is that not all that glitters is gold. I mean, just because a stock carries a massive dividend yield, it doesn’t mean the income is in the bag. It could be a yield trap.
Take WPP (LSE:WPP), for instance. The FTSE 100 advertising group currently has an 8% yield, which is the fourth-highest in the blue-chip index. It towers above the index’s 3.3% average and was 9%+ not long ago.
However, this is just the backwards-looking yield, and is the result of a falling share price. It doesn’t say what will come next.
WPP has lost 51% of its value this year. Often, this is a red flag. It signals that the market is deeply concerned about something, and this needs serious attention from would-be investors.
Dividends are not bullet-proof
Next, individual payouts are not guranteed. Returning to WPP, the firm just slashed its interim dividend by 50%, from 15p to 7.5p per share. So the real yield when investing today is under 8%.
In H1, WPP’s operating profit plunged 48%, while pre-tax profits crashed by 71%. This was due to falling client spending and fierce competition across the industry.
Meanwhile, investors are also concerned about the impact of AI on ad agencies, with new cutting-edge capabilities automating parts of ad creation and placement (the ‘where/when’ bit).
However, WPP has a new CEO at the helm, with a turnaround plan underway to survive in the age of AI. So it’s not inevitable that the company is doomed to perpetual decline.
Looking ahead, analysts see the dividend declining both this year and next. Yet, this still gives a well-covered forward yield of 6.3%, based on current forecasts. That’s around a fifth less than the headline 8%, though.
Personally, this isn’t a stock I am considering. The long-term income prospects seem too uncertain.
Tax realities
Third, most UK dividend income received outside of a Stocks and Shares ISA is taxed. So this needs to be taken into account.
Everyone gets a small dividend allowance of £500 per year. Anything above that is taxed, depending on your income band.
Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.
Still worth pursuing
With those reality checks out of the way, I want to end on a positive note by highlighting how it’s possible to mitigate these three things.
On yield traps, basic research can be done to assess a company’s financial health and prospects. Meanwhile, owning a diversified portfolio of shares can help cushion any possible dividend cuts.
Finally, any income and returns generated in a Stocks and Shares ISA is tax-free, with the annual contribution allowance of £20,000 a year. Investing £1,000 a month at a 9% return could build a £1m ISA portfolio within 25 years.
