There are two basic ways that share investors make money. The first is by generating capital gains from selling at a profit (buying low and selling high). The second is by collecting dividends — what are these, how do I earn them, and are they taxable?
What are dividends?
Dividends are cash distributions paid by companies to shareholders. For me, they are regular cash rewards for owning shares (sometimes, they get paid in shares, but this is unusual). Most UK-listed companies don’t pay dividends. Some businesses don’t generate big enough profits to return cash to shareholders. Also, some companies prefer to retain and reinvest profits into future growth.
However, the majority of large UK-listed companies pay dividends. Indeed, all but about a dozen members of the blue-chip FTSE 100 index do. Typically, companies pay these cash distributions half-yearly (as interim and final payments) or quarterly. Once paid into your account, this cash cannot be clawed back or reclaimed. But dividends are not guaranteed: during 2020’s Covid-19 crisis, many major firms cut or cancelled their payouts.
What to do with this cash?
I can spend my dividends how I like, just as with other cash receipts. But many big companies allow shareholders to immediately reinvest dividends back into new shares, often at low cost. So-called DRIPs (Dividend Re-Investment Plans) are common among major listed companies. In retirement, I’ll use this cash as extra passive income to support me. Before then, I don’t need this additional income, so I reinvest it into more shares. And over time, this reinvestment creates a ‘snowball’ effect that greatly enlarges my shareholdings.
The payment mechanics
Three things happen when a dividend is approved. First, the board of directors must agree to the payment, usually expressed in pence per share. Second, the board (working with its broker) sets an ‘ex-dividend date’. Only shareholders owning the shares before this date will qualify for the next cash payout. Third, the board agrees a payment date. To explain how this all works, I’m going to use one of my real-life shareholdings: pharma giant GlaxoSmithKline (LSE: GSK). GSK is my biggest individual holding, so I know it well.
Here’s the timetable for GSK’s Q2/2021 dividend of 19p per share. As you can see, GSK shares went ex-dividend on 19 August, so the next step is payment on 7 October. It’s typical for there to be a month or two between ex-dividend and payment dates. Now let’s say that I own 1,000 GSK shares. The next GSK dividend is set at 19p a share. Therefore, my reward for owning 1,000 GSK shares would be 1,000 x £0.19 = £190 cash. I don’t need this today, so I’ll reinvest it in more GSK shares. At the current share price of roughly 1,480p, £190 will buy another 12 GSK shares. These leaves £12.40 to be carried over to my next buy.
Are dividends taxable?
Dividends paid inside tax-free vehicles such as pensions and ISAs are not taxable. But others may or may not attract UK tax — it all depends on an individual’s tax situation. There is also a tax-free dividend allowance (£2,000 in this 2021/22 tax year). But they are taxed more lightly than earned income (basic rate of 7.5%, higher rate of 32.5%, Additional rate of 38.1%.). And that’s how these cash payments are helping me to get richer!