What are dividends? Are yields the key to financial freedom?

You can make money from stocks in two main ways – capital growth and dividend yield. Choosing stocks that pay dividends is one of the most popular and effective strategies for generating an income. In this article we explain how dividend investments work.

Many people’s investing goal is to create enough passive income to achieve ‘financial freedom’. This means different things to people. Essentially it refers to having enough money in investments to live the lifestyle you want without having to work. Unless you want to, of course.

There are different ways this can be achieved, for example you could amass a portfolio of shares and selling some of them periodically as needed, or own properties that generate rental income. Investing for dividend income is one of the simplest and most reliable routes.

In this article we cover:

• What are dividends?
• Why companies pay dividends
• Why do people invest in dividend paying stocks
• Which companies pay the highest dividends
• How can you invest in dividend yielding stocks
• Are dividends taxed?

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What are dividends?

Dividends are payments a company makes to its shareholders. The money a share pays out as a dividend is also called the yield. It is expressed as a percentage and is calculated by dividing the amount paid per share in pounds or pence by its price.

For example, a £100 share that pays a £6 dividend has a yield of 6%. 

Read More: When will interest rates go down and how will your investments be affected?

Dividends payments come from the money a company makes doing business. In certain circumstances a company will also borrow money to help pay its dividend, or use money from a third party investor. 

Dividend payments are paid quarterly in most cases, but some companies pay annually or monthly. Companies can also pay special dividends. These are one-off payments that are not part of the normal schedule.  

Why do companies pay dividends?

Shareholders effectively own a percentage of the company they have shares in. If that company makes a profit, they are therefore entitled to a percentage of that profit. After costs, of course.

In theory that’s what a dividend is – your share of the company’s profit. But things get a little more complicated in practice.

A company will often pay out a dividend to reward investors for buying and holding its shares. This helps support the share price, which is the primary concern of many executives running listed companies. 

Senior management teams are often incentivised to help raise the price of a company’s shares, and the dividend can have a significant impact on that. Therefore, maintaining an attractive dividend pay-out will be a high priority for some firms.

Such companies tend to be mature, established businesses. Newer companies, which are earlier in their corporate journeys, tend to reinvest money coming in to grow the business rather than hand it to shareholders. There are exceptions to this of course.  

Why do people invest in dividend paying stocks?

Dividends have been around as long as the stock market, but surged in prominence over the past decade and a half. 

Since the era of ultra-low interest rates began in the wake of the 2008 global financial crisis, sitting on cash savings has been a sure-fire way to financially tread water, at best. Cash interest and bond yields are closely correlated to the Bank of England’s base rate, so investors seeking to earn yield on their money have been primarily targeting dividends instead. 

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This has changed to a limited degree over the past two years as rates climbed back up to the 5% region. It is widely expected that central banks will cut them down again in the near future though. 

The average annual dividend yield of the FTSE 100 index is around 4%. Some years this comes in slightly under and some a touch over. While not a spectacular figure, it is significantly more than the base rate has been between 2008 and 2021. 

With an average yield of 4%, an investment pot of £500,000 invested in the FTSE 100 can provide an ongoing passive income of around £20,000 a year. Targeting just the highest paying dividend stocks in the index could bring in a significantly higher amount. 

This is not guaranteed, as is the case with interest on cash. That is because the amount of money a company has available to pay dividends can vary from year to year according to how well it does. The 4% average has tended to be a reliable yardstick in recent years however. 

Read more: When will interest rates fall?

Income versus accumulation

There are two options for how an investor can use a dividend. Income is simply taking the cash and using it to fund your lifestyle. This is where dividends meet the sought after ‘passive income’ role. The money will hit your account on a quarterly or annual basis and you are free to spend it as you please.

Accumulation means using the dividend payment to buy more of the shares that paid it. This can be a great long-term strategy as it creates what is called compounding – ‘the eighth wonder of the world’ according to Albert Einstein. The financial equivalent of a snowball rolling downhill. It will mean you do not have anything to spend immediately, but will greatly increase your wealth over multi-year timeframes. 

Choosing between these two paths is a an individual decision, based on financial needs, priorities, age and other variables. 

Which companies pay the highest dividends?

There is significant variation in the types of company that pay out healthy dividends. A dividend will depend on a number of factors, including the strategy of the management team, the profitability of the company and the macroeconomic situation.

Some industries tend to pay out higher dividends than others. Yields often reach 10% plus for some stocks. Commodities firms such as oil producers and miners are among the most reliable and highest-paying dividend stocks. 

Within the FTSE 100, companies such as Rio Tinto, Glencore and BP are often among the best payers.  

Financial services firms such as Aviva, M&G and Legal & General are also well represented in the highest and most consistent dividend payers.

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Tech companies, despite being some of the biggest and most successful firms, have not generally been high dividend payers. In their early days they usually run at a loss and they develop their products, and even when they start to make a profit chose to reinvest what they make to enable further growth.

There are exceptions to this, however. Vodafone – which straddles the worlds of tech and telecoms – has averaged a 8.08% dividend yield over the past five years, for example.

Investment trusts are another popular option. Also known as investment companies, these are stocks that have the sole purpose of investing money in other companies. Some investment trusts have a specific focus on generating an income form dividends. 

How can you invest in dividend yielding stocks?

There are various options for investing in dividend yield shares. Firstly you could just buy a basket of stocks that have a track record of consistently paying a relatively high dividend yield. 

As discussed above, commodities companies, banks and investment trusts would be good sectors to draw from. If you do this work yourself, you will not be paying any management fee, just platform and one-off brokerage fees. 

The second option is to buy an ETF that is tilted towards stocks with a high dividend yield. Many of the large ETF and passive investment firms offer a dividend tilted tracker product that provides exposure to a basket of appropriate stocks. The advantage of this is simplicity, and negating the need to identify a group of strong dividend stocks via your own research. There will be a small fee levied on these funds.

Read more: Is oil a good investment?

The third of the broad options is to buy an actively managed fund. These are run by fund managers who identify what they consider the best stocks to meet a particular aim, such as maximising the potential dividend income, or minimising the volatility in the dividend income you receive over time.

In some cases the managers will deliver a better result than a passive fund or picking your own stocks, but in many cases they will not, particularly once their fee is accounted for.  

Are dividends taxed?

Yes, unfortunately the tax man will want a slice of the money.  HMRC considers dividend income in similar terms to income from work. 

The sliding scale of tax brackets is the same, with basic, higher or additional rates being levied. The percentages due for each bracket are different though, at 8.75%, 33.75% and 39.35% respectively. 

Read more: What are ETFs and are they a good investment?

If you earn £10,000 or more in dividends during the tax year you must file a self-assessment return.

There is a small tax free allowance tax. As recently as the 2017/18 tax year this was £5000, but it was slashed to £2000 the following year, and cut in half to just £1000 in the 2023/24 tax year. 

Given this significant tax burden, it is crucial to take advantage of the ISA and SIPP tax wrappers. These will shield any dividend income generated within them from HMRC.