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Looking for income from investment trusts

Investment trusts might be able to deliver a steady income to investors, even in times of crisis. We explain how they work.

The value of investments can fall as well as rise and you could get back less than you invest. If you’re not sure about investing, seek independent advice. Tax rules can change and their effects on you will depend on your individual circumstances.

What you’ll learn:

  • How investment trusts can potentially provide a steady income.
  • What the risks are.
  • How dividends are taxed.

When it comes to investing for income many investors opt for a fund that invests in dividend-paying firms, which helps to reduce the volatility and risk of losses that can come with investing in just individual shares.

Open-ended funds, such as unit trusts or open-ended investment companies (OEICs) typically contain a very broad spread of stocks.

However, these aren’t your only options. Investment trusts, another type of collective investment scheme, have a number of advantages for income seekers.

Here, we examine the benefits and risks of holding investment trusts for income.

Income and investment trusts

While open-ended funds are required to pass on all of the dividend income they receive from the companies in their portfolios, investment trusts don’t have to.

Instead, they’re allowed to keep some of the dividends they earn back, to supplement income payments to shareholders in years when there might be a shortfall.

This can be potentially valuable to investors, because dividend payments from companies will rise and fall – and are sometimes even cancelled altogether if a firm finds itself in some financial trouble.

But in a buoyant year for dividends, investment trusts can retain some of the payouts they receive, as the current rules allow them to keep up to 15% of annual income. This means that during tougher periods, they can draw down on their reserves to maintain or increase their own payments to investors.

The effect is to smooth out income payments that investment trusts deliver. The payouts made by open-ended funds, by contrast, will automatically rise and fall in line with the dividends they earn on their investments.

Consistent increases in dividends

The ability of investment trusts to hold back income payments in good times has allowed some to build up a very strong track record of consistently increasing dividends.

The Association of Investment Companies (AIC), the trade body to which many investment trusts belong, maintains a record of vehicles which have raised their dividends every year without fail for an extended period - even during crises such as the dotcom collapse in the early 2000s and the credit crunch in 2008.

The AIC’s last review showed that there were 20 trusts, which had increased their dividends every year for the past 20 years at least. One fund in particular, the City of London Investment Trust has now actually managed to raise its dividend every year for the past 50 years, the first to ever achieve such a feat.

But while many trusts have been able to raise dividends consistently in the past, this is no guarantee they’ll be able to continue doing so in the future. Their past performance is not a reliable indicator of their future performance. Always remember too that the value of your investments can fall as well as rise and you could get back less than you invest.

The drawbacks to dividend smoothing and investment trusts

Against all this, investors should recognise there will be years in which open-ended funds offer more income than investment trusts, since they’re passing on everything they earn.

What’s more, investment trusts’ reserve funds only provide a certain amount of protection. Once they’re exhausted, trusts have to cut dividends too. However, if shareholders approve, they’re able to pay income out of their capital profits – for example, by selling some shares.

But while the rules applying to investment trusts can be beneficial for income seekers there are a numbers of risks to also consider. The primary difference between investment trusts and open-ended funds is that they are stock market listed and therefore closed-ended. In other words there are a limited number of shares in existence, so if you want to invest after a trust’s launch, you can only do so if another investor wants to sell their stock.

Market demand also dictates an investment trust's share price, which can move either above or below the value of the assets that it holds - called the Net Asset Value (NAV). If a trust’s share price moves below its NAV, it is said to be trading at a discount, if it rises above, it is trading at a premium. Investors often seek out trusts on a discount because it means they can pick up the shares at a cheaper price.

For instance, if a trust is trading at a 10% discount, you can get an investment which itself represents £100 worth of shares for £90 and in addition, from an income perspective, you'll continue to receive dividend income derived from £100 worth of assets.

But if you invest when a trust is on a premium, you will be paying over the odds. If a trust boasts a high yield and/or a decent income track record, don’t be surprised to find it trading at a premium, as such vehicles tend to be very popular.

Find out more about introductions to investment trusts

How dividends are taxed

It’s also important to think about the tax treatment of your dividend income, whether from open-ended funds or investment trusts.

Under Dividend Allowance rules, introduced in April 2016, taxpayers can receive up to £5,000 in dividend income each year without paying any tax at all. Above this threshold, basic-rate taxpayers have to pay 7.5% income tax on the excess, while higher-rate and additional-rate taxpayers have to pay 32.5% and 38.1% respectively. Changes announced in the 2017 March Budget mean that Dividend Allowance will reduce to £2,000 with effect from April 2018, so tax-efficient wrappers such as ISAs will become more important for investors seeking to mitigate their increased tax exposure.

Remember that tax rules might change in future and their effects on you depend on your individual circumstances.

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