Long Live Equity Income investing

Budget - Dividend Income Taxation Changes: The Budget included some unexpected changes to the way that dividend income is taxed for individuals. The present system involves adding a notional credit to a dividend that a non-tax payer cannot access. A basic rate tax-payer effectively uses that credit to pay the income tax due, whilst a higher rate tax-payer pays 32.5% or 37.5% tax depending on their marginal rate of tax, less the tax credit. The proposal is that in future the first £5,000 of dividend income will be tax free, with basic rate tax-payers paying tax at 7.5% and higher rate tax-payers at 32.5%. So (hoping my steam-driven Casio has worked) at present £25,000 of dividend income for a basic rate tax-payer levies no further tax. In future though, the first £5,000 is tax free, but the next £20,000 attracts tax at 7.5%, being a new liability of £1,500. A 40% tax payer, receiving the same £25,000 income would currently pay extra tax at 32.5% on the grossed up £27,778 being £9027.85, less the £2,778 equalling £6,249.85. In future he will pay 32.5% above £5,000, i.e. on £20,000, being £6,500, an increase of £250.15.

These may be considerable levels of dividend income, but they do mean that the balance between income returns and capital returns has been tilted. As an aside, those using dividends as a means of extracting income from small private companies will be caught by this. It is a key point though that income generated within tax efficient wrappers (i.e. SIPPs and ISAs) will not be affected. So the attraction of these vehicles increases further for those who do not yet utilize their allowances.

What does this mean for equity stock selection though? I have never been a big fan of high yielding stocks with little growth prospects (in profits or payouts) and that remains the case. The core hunting ground of solid companies growing profits and using that cash to invest in growth and return cash to shareholders remains an attractive proposition that, in my view, outweighs the drag of the new tax rules. Of course, one other route is to re-balance portfolios towards capital growth stocks, where dividends are a much smaller part of expected returns. The problem here is that those stocks are often in a less mature stage of development, which can mean faster growth but also higher risk. This has to be taken into account in portfolio construction. So the case for income growth investing remains intact in my opinion, despite these major taxation changes. (Neil Cumming^, 9^th July 2015)

These comments are not a personal recommendation to deal. Any investments can fall as well as rise in value, so you could get back less than you invest. I may have a financial interest in some of the stocks written about. www.dividendpower.co.uk or e-mail at info@dividendpower.co.uk  Twitter:  @DividendPower