Dividends explained

When you invest directly in shares, you can generate returns in two different ways. The shares could rise in value, or the company could pay you dividends.

Dividends can significantly boost your profits, or provide an income to live on. Here we’ll explain how dividends work, what you need to think about, and how to navigate dividend tax.

How do dividends work?

A company pays out dividends when it has surplus money it wants to hand to investors. It is the company’s board of directors who decide whether to pay out a dividend, and how big that dividend is.

Once a company has declared it’s paying a dividend, it will announce the dividend value. This will be given in an amount of pence per share. Often you might see it represented as a percentage – called the dividend ‘yield’ – which is calculated as the share price divided by the dividend amount. For example, a share price of 100p and a dividend of 3p would give you a 3% yield.

Not every shareholder is guaranteed to receive a dividend. To qualify, you’ll need to have owned the stock before it goes ‘ex dividend’, a cut-off date which is stated on the company’s website.

When do companies pay dividends?

There isn’t a set schedule, as it varies from business to business. But usually a company pays dividends quarterly or twice a year. They can also issue them ad hoc, which is known as a ‘special dividend’.

Even if a business has paid dividends before, it isn’t guaranteed to pay them again, so you shouldn’t rely on them. But looking at a company’s dividend policy and past track record will give you an indication of whether they prioritise dividends.

Can a company stop paying dividends?

Companies have no obligation to pay dividends to shareholders and sometimes there are occasions when companies turn down the dividend taps for a short while.  Even when they do dole out the cash, they have complete discretion whether to pay at the same level as the previous dividend, pay more or pay less. 

A company’s cash pile is used to fund dividends and sometimes management decides there’s a better use for that money than handing it to shareholders. 

Examples scenarios where a company may decide not to pay dividends:

• Paying down debt
• Helping to fund an acquisition
• Reacting to volatile earnings
• Selling divisions and remaining operations generate less cash flow
• Rebuilding their finances

The good news for investors is that dividend cuts or cancellations don’t happy very often. Dividends across the FTSE 100 index have increased every year apart from two since 2015. One of those years was 2020 when companies preserved cash during the global pandemic.

Dividends versus share buybacks 

Dividends aren’t the only way for a company to deploy surplus cash. Companies also like to buy back shares as this can have multiple benefits.

1. It creates an active buyer of stock in the market, which can push up the share price.
2. Companies typically cancel the shares once they buy them back, which has a positive impact on earnings per share. 

Companies often describe share buybacks as a way of ‘returning’ cash to shareholders, but an investor wouldn’t see a cash payment in their account as that only happens with dividends.

Do ETFs, funds and investment trusts pay dividends?

Dividend payments are often associated with stocks, but exchange-traded funds (ETFs), funds and investment trusts can also pay dividends.

If you prefer to have diversified exposure through funds rather than individual shares, investment trusts have an advantage when faced with dividend cuts or cancellations. 

Investment trusts are a type of fund that can hold back 15% of annual revenue in reserve to help smooth out dividend payments. So, if a stock in its portfolio has to cut back on dividends temporarily, the investment trust can use its revenue reserves to make up for the shortfall and ensure its own shareholders still receive a steady dividend.

Do I pay tax on dividends?

Yes, dividends are subject to tax. But if you hold your shares in a tax-efficient account such as a pension or Stocks and shares ISA, dividend tax isn’t payable. You also won’t need to pay capital gains tax on any gains your investments make.

Learn more about ISA allowances

If you hold the shares in a Dealing account, dividend tax is payable past a certain point. You can earn up to £500 in dividends this tax year before you have to pay tax. If your investments generate more than that in a tax year, the rate of tax you pay will depend on your income tax rate. If you’re a basic-rate taxpayer you’ll pay 8.75% tax on your dividends, and if you’re a higher-rate taxpayer you’ll pay 33.75%. It’s 39.35% if you’re an additional-rate taxpayer.

What is reinvesting dividends?

One way to boost the overall return on your investment is to reinvest your dividends. This is when you use your dividend payout to buy more shares in the company. It’s a popular approach for investors looking for capital growth rather than income.

Some platforms, including AJ Bell, allow you to automatically reinvest your dividends, so you don’t have to do it manually. Doing this can have a snowball effect on your total return, assuming the company’s dividend doesn’t fall. Reinvesting your dividends means you'll own more shares in the company. Owning more shares means you'll receive a bigger dividend next time – which you can reinvest to buy even more shares in the company.

How do I reinvest dividends with AJ Bell?

Our dividend reinvestment service allows you to have dividend cash automatically reinvested to buy more shares. You can choose to have all eligible dividends reinvested or select individual shares. Eligible dividends are those paid by UK listed shares, investment trusts and ETFs only and includes special dividends. Our service doesn't allow you to reinvest dividends for international shares, bonds or funds.

You'll need to set up the dividend reinvestment service separately for each account you hold. The charge for each dividend reinvested is £1.50.

We will reinvest dividends from any investments you chose to include in the dividend reinvestment service on the second working day following the day that we credit the cash dividend to your account. 

Learn more about how to use the dividend reinvestment service

Can I reinvest dividends in an ISA?

Yes, you can. And the great thing about reinvesting dividends in your ISA is that it doesn’t count towards your £20,000 annual ISA allowance. So you don’t need to factor it into your calculations when working out how much of your ISA allowance you’ve used up.