Terry Smith - the problem with investing for dividends

[Julian]

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Those calculations are rather simplistic - for instance, they don't take inflation into account - but give the general flavour of what happens for one scenario. That particular scenario is not too far from what happened to my own HYP during the financial crisis about a decade ago - its dividend income dropped by about a third in a year and with a bit more allowed to compensate for inflation, 40% is probably a bit more of a drop than it experienced. Just how quick the recovery was, I don't really know (*) but the schedule above doesn't seem too unreasonable.

To do the job properly, I would want to check out a few different scenarios - a prolonged period of high inflation with dividends taking quite a long time to start rising in line with inflation might be another, for instance. But generally speaking, I would always want at least some safety margin of the HYP-generated income over the income I actually required, to give a decent hope of replenishing the cash reserve afterwards if I did need to use it and to deal with something going wrong long-term: for an indefinitely-long impairment to the HYP's dividend income, the protection given by such a safety margin will last indefinitely, whereas any cash reserve will eventually dwindle to zero.
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... it's important to consider multiple scenarios of what could go wrong and get a good balance of dealing with all of them.

(*) I was still building it up with capital from other sources for some time afterwards, so it would need to be unitised for me to get a proper idea - and I'm not even going to attempt retrospective unitisation that far back!
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When attempting to "consider multiple scenarios" it is usually things like falls in dividend payments due to something like the financial crisis and/or unexpectedly high inflation that are, at least for me, the first adverse effects on income that come to mind. If someone is going to follow your advice though and consider multiple scenarios then one another potential income-impacting event that some might want to consider is further changes in the tax treatment of dividend income. In the UK we have already seen the change from the tax credit scheme to the (diminishing) tax-free dividend allowance plus 7.5%/32.5%/38.1% tax rates which, at least for me, resulted in a noticeable hit on my net income once I had made the necessary upward adjustment to my monthly tax accrual.

Future unannounced tax changes are impossible to forecast of course but if trying to analyse various income fall scenarios I think the possibility is worth remembering. Personally I have modelled what the effect would be on my net income were dividend taxation to be fully aligned with the current PAYE tax scheme, i.e. 20%/40%/45% with the same banding and the separate dividend tax allowance totally abolished. I'm not suggesting that would happen but it is the "worst-case"(*) tax scenario that I model.

(*) "Worst-case" in quotes because it is of course by no means the worst possible case. Something like NI getting merged with basic income tax and dividends falling under that scheme could result in the rates being higher than 20%/40%/45%, or almost certainly even worse a move back the the 1970s "tax them until the pips squeak" era that I think resulted in dividend tax rates up to 98% (or pretty close to that). I'm not trying to make any political or moral points and anyone who wants to model any possible adverse tax effects would have to choose their own "worst-case" scenario to model, but some might want to consider it.

- Julian

[Gengulphus]

When attempting to "consider multiple scenarios" it is usually things like falls in dividend payments due to something like the financial crisis and/or unexpectedly high inflation that are, at least for me, the first adverse effects on income that come to mind. If someone is going to follow your advice though and consider multiple scenarios then one another potential income-impacting event that some might want to consider is further changes in the tax treatment of dividend income. ...

Sort of agreed, but I think big changes to the tax treatment of dividends are likely to be accompanied by similar-sized changes to tax more generally. For example, I think your 'worst-case' scenario of the Income Tax rates on dividends rising to equal the 20%/40%/45% rates on more general income is fairly unlikely to happen, and very unlikely to last if it does happen. The reason for that is simply that doing so will create an imbalance in the overall tax rates faced by small private company owners, between paying themselves with salaries and paying themselves with dividends. There was apparently such an imbalance before the abolition of the notional tax credit and its 'replacement' by the dividend allowance (*), and I did see quite a lot of evidence of small private company owners being advised to draw only a pretty minimal salary and pay themselves anything over that as dividends: corporation tax on a small company and the effective Income Tax on the dividends after the tax credit added up to significantly less than Income Tax and National Insurance contributions on a salary... So I can believe that the increase in dividend taxation, which was presented as correcting that imbalance, did actually do that. But I'm also fairly certain that increasing it right up to the 20%/40%/45% rates would go too far and create a significant imbalance in the opposite direction - so the advice that a government contemplating doing that would get from HMRC would probably be "no point, unless you increase suitable other taxes as well to restore the balance".

That doesn't mean that I think one can rule out some further adjustments to the tax treatment of dividends that are unaccompanied by other taxation changes, just that I very much doubt they would go as far as the 20%/40%/45% rates, and if they did, they would be followed by some other taxation changes to restore the balance, probably within a few years (not necessarily reversing them to reduce dividend taxation - increases to other taxation would also restore the balance).

All of which means that I'm a lot more concerned about taxation increases in general than about specific changes to dividend taxation. And actually, if I were to pick some low tax rates that might be a political target, I think the 10%/20%/20% CGT rates are a more obvious political target than the 7.5%/32.5%/38.1% Income Tax rates on dividends...

Anyway, the risk of future more general tax increases is certainly one that I would want to cater for - but it would apply regardless of how I was intending to get my income, and so I would want to try to take it into account when setting the "income I need" figure, rather than when looking specifically at high-yield share investing.

(*) Which was accompanied by at least one official tax rate change, but that was a reduction of the dividend basic rate from 10% to 7.5%. The higher rate was unchanged at 32.5%, and I'm not certain whether the additional rate was changed at all, but I'm pretty certain that if it was, it was a pretty small change. Like you, I experienced a hit on the tax due on my dividend income - but at least in my case, that was due to the dividend allowance and the small reduction in the basic rate being a totally inadequate replacement for the notional tax credits, not to changes in the tax rates.

Gengulphus

[monabri]

Need money to pay bills? Cash some units in.....oh!