What is dividend investing and how do I start?

If you’re thinking about dividend investing to help generate income or long-term returns, there’s much to consider. 

We explore what dividend investing is, how it works, and the pros and cons.  

What is a dividend? 

A dividend is a regular cash payment or additional shares from a company to shareholders as a way of distributing a portion of its profits. If a company doesn’t make a profit, it cannot pay a dividend.  

Dividends can be useful for investors by providing a regular source of income, or if reinvested, to buy more shares, increase their investment, and benefit from compound interest.  

Not all companies pay dividends, as some may prefer to reinvest in the business. Companies can choose to pay off one-off dividends, known as special dividends, that can be used to distribute surplus cash. 

A special dividend can occur in many scenarios, including after a company sells a specific division or after reporting strong earnings. 

What is dividend investing, and how does it work? 

Dividend investing is when you invest in dividend-paying stocks. An appealing feature of it is that companies pay part of their profits as a dividend, which you can take as cash or shares or choose to reinvest.  

Dividends can generate an income, or you can build long-term returns by reinvesting. They are usually paid out on a quarterly or annual basis.  

When a company has a profit, it can propose a dividend either as cash or additional shares, the latter of which tends to hold the same value as the cash dividend.  

If you’re considering dividend investing, it’s essential to have a comprehensive understanding of the company rather than focusing solely on the dividend yield, which represents how much a company pays out in dividends annually relative to its share price. 

The average FTSE 100 dividend yield is around 3.5%, but some companies can offer 5% or more. While this is appealing, it’s worth being wary of the risks, as sometimes a high dividend yield can imply a ‘dividend trap.’ 

A dividend yield trap occurs when a company has a high dividend yield supported by a falling share price while overall financial health is weak. This could potentially result in future earnings downgrades and put the dividend at risk. 

Why do companies pay dividends, and are these guaranteed? 

Many companies pay out regular dividends to share part of their profits, as well as reward investors and incentivise them to stay invested. While a company can pay out dividends, it doesn’t have to, and they are not guaranteed.  

If a company is struggling with profitability and wants to save money, it could either reduce the dividend or not pay one at all. This can have a significant impact on the share price.  

For this reason, investors must do their research and consider the following before investing their money, including: 

• Is the company in good financial health? 

• What are the opportunities and challenges for the company? 

• What are the potential drivers for growth in the sector? 

• What are the potential challenges for the sector? 

• What’s the long-term outlook? 

There are financial metrics that can help you understand a company, but you can also talk to a financial adviser who can build a portfolio based on your long-term goals.  

Do I pay tax on dividends in the UK? 

You may have to pay tax on dividends in the UK if you exceed your personal allowance and dividend allowance. 

The standard personal allowance is £12,570 a year, which is the amount of income you don’t have to pay tax on. Your personal allowance falls by £1 for every £2 you earn over £100,000 and no longer exists if you earn over £125,140. 

There’s also the dividend allowance, which is £500 a year, so you pay tax on any dividend income above this allowance at the following rates: 

• 8.75% for basic-rate taxpayers 

• 33.75% for higher-rate taxpayers 

• 39.35% for additional rate taxpayers 

This handy tool on GOV.UK may help you figure out how much tax you need to pay.  

How do I start dividend investing? 

Before you start dividend investing, conducting thorough research is essential.  

For example, you should understand what the company does, how it generates a profit, the challenges and opportunities it faces, its history of dividend payouts, the share price, annual financial reports, and explore its news coverage. 

Consider what you want to achieve via dividend investing, how it’ll help your long-term goals, and how you want to invest. For example, you could invest in dividend-paying companies via an investing platform or consult a financial adviser who can help you build a diversified portfolio.  

You could also consider a high-dividend exchange-traded fund (ETF), a real estate investment trust (REIT), a royal income trust, or a dividend fund. It’s a good idea to get expert financial advice before investing. 

It’s also worth considering the costs of investing as these will apply via investing platforms or if you let a financial adviser manage your portfolio for you.  

How do I find dividend-paying companies? 

Many companies may share a list of ‘high-yielding’ or ‘top’ dividend stocks, but these should be not be seen as financial advice and, instead, ideas to consider following research. 

You could use a stock screener to discover dividend-paying stocks if you’re unsure where to start. Then, you should conduct in-depth research to determine whether any are of interest – and remember to consider whether the dividends are sustainable. 

What are the advantages and disadvantages of dividend investing? 

Before investing in dividend-paying companies, there are many advantages and disadvantages to consider. 

The pros of dividend investing 

• You can benefit from a regular income: If you’re seeking regular income to support you, such as in retirement, dividend-paying companies can be useful.  

• Investing in dividend-paying companies may be less risky than other assets: Companies that pay a dividend are likely to be higher quality and more stable, as well as have a history of navigating volatility. A dividend-paying company may have a history of consistently paying dividends or regularly increasing its dividend payments.  

• You can grow your income by reinvesting: You can choose to reinvest in the company in the hopes of better returns and benefit from compound interest.  

• Dividends are taxed at a lower rate than income: Instead of dividends being taxed at income tax rates (20%, 40%, or 45%), they are taxed at 8.75%, 33.75%, or 39.35%, respectively.  

The cons of dividend investing 

• Dividends are not guaranteed: While looking for companies with a history of paying dividends can be helpful, it doesn’t guarantee that they’ll continue to pay in the future. If a company is struggling, it may choose to reduce or get rid of its dividend payments. 

• The value of your investment can rise and fall: Similar to other investments, your money is at risk with dividend-paying companies. 

• Your level of returns may be lower than elsewhere: Dividend-paying stocks may experience stable but lower growth than those with high growth potential.  

• Looking for high yields could impact your portfolio: If you’re focusing on high-yield dividend stocks, you may miss out on other areas to invest in that have attractive growth. There’s also the risk of falling for a dividend trap if payouts are unsustainable. 

Get expert financial advice 

Investing can yield long-term returns, but there’s much to consider before starting. 

While you can create your own portfolio, including selecting your investments, it can be challenging to ensure it is diversified and can withstand volatility. 

Unbiased can quickly match you with a qualified financial adviser who can help you decide on an investment strategy and portfolio based on your long-term goals.