Dividend Investing - Investing for Income

By PURSUIT of FIRE on in Invest Money - Level 6

There are generally two schools of thought when it comes to FIRE dividend investing about the best way to invest.

  1. Invest using growth stocks and when the time comes to retire, withdraw 4% and increase the amount each year with inflation. This is the method I have already described in “What is the FIRE movement?”.
  2. Invest in dividend paying stocks that pay out dividends at regular intervals and live off the dividends without selling the stocks.

There is no right answer, and I use a mix of both growth stocks and dividend paying stocks in my portfolio.

Generally stocks that pay a high dividend aren’t growing companies so your underlying money may not grow as much as if it was invested in growing companies.

Most companies pay dividends either Quarterly, Bi-Annually or Annually. However, it is possible to invest in funds that pay out dividends monthly, or pick a mixture of funds that means you get an income every month. Much like you would a salary.

Also if you invest the money in a tax sheltered account such as a Stocks and Shares ISA you will get this income tax free.

Generally the annual dividend payout from most dividend funds is around 3 - 5%.

Just make sure you pick the Income version of the fund and not the Accumulation version otherwise the dividends will be reinvested back into the stock automatically.

What are the downsides of dividend investing for FIRE?

Earning income monthly without going to work is the dream. However, there are some downsides to receiving dividends compared to investing in growth stocks.

Tax

If you invest in growth accumulation funds, all the money you would have received in dividends go back into the value of the fund. You never actually see this money and as such you never have to pay tax on it.

So if you are considering investing in dividend stocks, make sure it is in a tax fee account such as your stocks and shares ISA.

If you are investing in another account that isn’t tax free then you will find that the tax on dividends works out higher than the tax you would have paid if you had simply sold some of the stock.

Tax on Dividends

In 2019/2020 everyone receives a £2,000 tax-free allowance and then dividends are taxed at the following rates:

  • Basic-rate taxpayers pay 7.5% on dividend income.
  • Higher-rate taxpayers pay 32.5% on dividend income.
  • Additional-rate taxpayers pay 38.1% on dividend income.

Tax on Selling Shares

If you are selling shares you pay Capital Gains tax.

Capital Gains tax is only paid on the profits not the total amount. Working out the profits on shares you have bought over the years is a bit of a nightmare. The government try and simplify it for us but that is one for another post.

In short, if you buy shares at £10 a share and then you sell them in 5 years at £15 a share you only pay tax on the £5 difference.

There is also an annual capital gains tax exception of £12,000 as of 2019/2020. The rest is charged at the following rates:

  • Basic-rate taxpayers pay 10% on share profits.
  • Higher-rate taxpayers pay 20% on share profits.

So you can see with the large exemption, the fact you only pay tax on the profits and the lower tax for higher-rate earners it is a no brainer, don’t do dividend investing in the account you have to pay tax on.

Fees

If your plans are to reinvest the income you receive from dividends, you might be better off just investing in growth funds.

A lot of funds have fees that you have to pay when you purchase it, as a result you will lose money every time you buy more, which you could have kept if it was automatically reinvested in an accumulation fund.

Opportunity Cost

Generally companies that are growing don’t pay dividends. As a result you might be leaving money on the table by investing for income instead of growth.

This isn’t always the case though and it is still possible to find dividend funds that have a healthy growth as well as a healthy dividend payout.

Passive Income

Dividends are one of the few methods of earning truly passive income.

There is a scale when it comes to earning income.

Active vs Passive Income

At one end of the scale you have active income. This is where you actively have to work to earn money. So the salary from your job would be classed as active income as you have to trade 40 hours a week plus commuting to earn money.

At the other end of the scale you have passive income. This is where you don’t have to do anything and the money comes rolling in, potentially even while you sleep.

Once you buy dividend stocks they will continue to generate you income without you having to work for it.

All income you earn will sit somewhere on this scale. Your aim should be to try and move as much of your active income over passive income.



AUTHOR BIO

Alex started Pursuit of FIRE in 2019 to try and help people reach financial independence. He has spent nearly a decade working as a software developer in the finance industry and now is looking towards early retirement so he can spend more time with his young family.