Reinvesting income can be a major factor in long-term returns for investors.
Shareholders in companies listed on London’s main market received a record £110.5bn in dividend payments during 2019, up 10.7% compared to the previous year, according to latest analysis by Link Asset Services.
Whether you invest in individual shares, funds, or a combination of these, the decision to reinvest income from your investments, will, of course, depend on your personal circumstances. You’ll also need to consider whether you want to increase your investment in a particular company or fund simply because you received a dividend from it. You might decide you’d prefer to invest dividends elsewhere in the hope of achieving returns.
Reinvesting dividends or interest may seem a logical approach to help your investments grow if, for example, you already have enough income from your job, and you’re saving for a financial goal which is many years away, such as retirement.
If, however, you need a bit of extra income each month to supplement either your salary or pensions, taking the dividends or interest from your investments as cash could prove invaluable.
Remember that like the value of the investments that produce them, dividends and interest payments can fall as well as rise, and past performance, including past dividend payments, should not be relied on as a guide to what could happen in future.
Benefits and drawbacks of income reinvestment
The main benefit of reinvesting income from your investments is that it is the cheapest and easiest way to increase your holdings over time. Any reinvested income can be used to buy more shares which will potentially grow in value and boost your overall returns. In simple terms, your returns also earn returns, which is known as compounding. For example, imagine you buy a share for £50 which pays you a £3 dividend in the first year, and the share goes up in value by 5%. Assuming you reinvest your dividend, this means that your investment would be worth £55.50 by the end of the year.
If you then received another £3 dividend in the second year, and the value of your share increased by 10% in that year, your investment would be worth £64.05 (£55.50 x 10% gain, plus your next £3 reinvested dividend).
Even though you’ve only received a total of £6 in dividends, if you’d reinvested these, your investment would have increased in value by £8.55 in total. This figure includes not only gains on your original £50 investment, but also on your reinvested £6 of dividends. Please note that these figures have simply been chosen to illustrate the point – they are not forecasts of future performance. If the dividend is maintained and reinvested but the share price falls, your investments could be worth less than you put in.
For example, if you buy the same share costing £50 and receive a £3 dividend in the first year, but the share goes down in value by 5%, assuming you reinvest your dividend, your investment would be worth £50.50 by the end of the year. If you then received another £3 dividend in the second year, but the value of your share fell by 10% that year, your investment would be worth £48.45 (£50.50 minus 10% loss, plus your next £3 reinvested dividend).
Another potential downside is that if you decide to automatically reinvest income, you won’t be able choose the price at which you will be buying your extra shares, so this could happen when the price is high or low. You will also need to weigh up whether you are comfortable putting more money into the investment that is providing you with an income.
Remember that putting your income back into the stock market rather than taking it as cash means you could lose it, or see its value fall.
How to reinvest income
When you put money into an investment fund, you are usually given the option of either selecting ‘accumulation’ units, or ‘income’ units, also sometimes known as distribution units.
Buying accumulation units means that any income received by the fund, whether this is dividends from shares, coupon interest from bonds, or rental income from property, is retained in the fund and buys more underlying assets for your units in the fund. If you choose income units, then any income the fund earns will be paid out to you, usually once or twice a year, although some funds make quarterly or monthly income payments.
If you invest in shares directly, and want your dividends to be reinvested automatically, you can usually sign up to what is known as automatic dividend reinvestment (ADR).
This means that any income you receive is automatically reinvested, rather than you taking the cash and using it to buy additional shares yourself. If you’re unsure where to invest, seek professional financial advice.
Understand the tax position
When a fund or shares are held in a tax-efficient account like an Individual Savings Account (ISA) or Self-Invested Personal Pension (SIPP) there’s no income tax, capital gains tax (CGT) or dividend tax to pay.
When held outside one of these wrappers, your investment is subject to income tax, capital gains tax (CGT) and dividend tax rules.
Even outside of an ISA or SIPP, you can receive up to £2,000 in dividend income in the current 2020-21 tax year, without having to pay any tax on this income.
Dividends above the £2,000 threshold are subject to tax at 7.5% for basic-rate taxpayers, rising to 32.5% and 38.1% respectively for higher-rate and additional-rate taxpayers.
Under personal savings allowance rules, basic rate taxpayers can earn £1,000 in savings income before paying income tax, whilst higher rate taxpayers can earn £500. Additional rate taxpayers don’t get a savings allowance. Savings income includes interest from bank and building society accounts and interest distributions from investment funds such as authorised unit trusts (AUTS) and Open Ended Investment Companies (OEICS). If all your income of this type exceeds the allowance, you will have a tax liability for the excess.
Investors who receive more than their allowance must declare their income on a tax return form and pay tax on it. The amount you’ll have to pay depends on your tax rate, so if you’re a basic rate taxpayer, you’ll pay tax at 20%, rising to 40% if you’re a higher rate taxpayer and 45% if you’re an additional rate taxpayer.
When you come to sell accumulation units, you’ll pay Capital Gains Tax (CGT) on any increase in value that exceeds your annual CGT annual allowance, which for the 2020-21 tax year is £12,300. CGT will be payable on the value of the accumulation units when they’re sold, minus the original investment and any income you’ve reinvested.
You should therefore keep careful records of all the notional distributions you receive, so that when you sell your holding you can work out the proportion of your sale proceeds that represents a capital gain. Your fund manager should issue you with a tax voucher after the end of the tax year on 5 April giving you details of all rebates, dividends and interest distributions, and any tax deducted at source on this income during the preceding tax year.
Please bear in mind that tax rules might change in future and their effects on you depend on your individual circumstances, which can also change over time.
Remember too that investments can fall as well as rise and you may get back less than you invested. Past performance is not a reliable indicator of future performance.