The Dividend Allowance: what it is, how to benefit and the best share picks

When you invest in stocks and shares in a company you will become a shareholder which entitles you to a cut of the profits, typically paid every quarter or twice a year in the form of dividends.

This way of investing is about to get more attractive thanks to an impending Dividend Allowance, which was first announced by the Chancellor in the summer Budget.

What is the Dividend Allowance?

From 6^th April 2016 the first £5,000 of dividends you receive form your investments will be tax-free.

For dividends over £5,000, tax will be applied according to the following tax bands:

• 7.5% applies on dividend income within the basic rate band (20%)
• 32.5% applies on dividend income that falls within the higher rate tax band (40%)
• 38.1% applies on dividend income that falls within the additional rate tax band (45%)

On top of this new tax-free allowance, dividends you receive within a stocks and shares ISA and pension funds will also continue to be exempt from tax.

How to benefit

To take advantage of the changes you will need to build a portfolio of investments and try to maximise your allowance.

Once you’ve hit a £5,000 profit though you should consider sheltering taxable investments in a stocks and shares ISA to avoid the 7.5%-38.1% tax. The allowance is 15,240 this tax year, but will rise to £20,000 next year. Read: Beginner's guide to stocks & shares ISAs.

That said you should try to be clever with yield, according to Danny Cox from Hargreaves Lansdown. A diverse portfolio will have shares and funds which generate different levels of dividend income yield.

Sheltering investments that generate the highest yields in an ISA (which does not limit how much you are allowed to make tax-free) and leaving those with lower yields outside will minimise income tax due.

For example, a taxable portfolio of £125,000 with a yield of 4% will generate £5,000 a year and use up the Dividend Allowance. However, a portfolio of £500,000 yielding 1% generates the same £5,000 a year.

He also points out that the £5,000 allowance is per individual so married couples could consider spreading their taxable portfolio between them to make full use of both entitlements.

How to start investing

Shares are traded on loads of different types of indices around the world, like the FTSE 100, which tracks the 100 largest companies in the UK, or the S&P500, which follows the fortunes of the top 500 US companies.

Anyone that has access to a computer and some spare cash can invest in stocks and shares with online stockbrokers like Alliance Trust, Charles Stanley or Hargreaves Lansdown.

Alternatively, you can get an investment company to do the hard work for you. These companies have fund manages which decide which assets to buy in order to build a diverse portfolio on behalf of investors.

Read: Beginner's guide to buying and selling shares and Beginner's guide to investment platforms for more.

Where to put your money

2016 has kicked off with a rocky start for the markets and a number of high profile companies like Barclays have cut their dividend this year. That said companies in other sectors like Aviva have been more successful raising their dividend by 15%.

You should do some research about where you want to put your money by looking at a few different indices and researching companies, sectors, dividend yield and price to earnings ratios.

Cliff D’Arcy revealed his top five picks in: Best dividend shares: where to invest ahead of tax-free dividend allowance.

The Association of Investment Companies (AIC) has published a list of ‘dividend heroes’ which reveal the top investment companies which have managed to increase their dividends each year for the last 20 years, which might be worth looking into.

Source: AIC using Morningstar

The AIC also rounded up expert opinion from leading investment companies about the sectors and firms likely to see dividend increases in 2016.

Alex Crooke, Manage of Banker’s Investment Trust said: “It remains possible to find companies in all regions that are expected to raise their dividends by around 5-6% but as always, it is essential not to overpay for this income. As a result, we have a preference for the telecoms and healthcare sectors where we can find stocks with decent dividend yields, strong free cash flow characteristics and attractive dividend growth potential.”

While Job Curtis, Manager of City of London Investment Trust said: “The fall in sterling compared with the US dollar in recent months has given a positive translation effect to those dividend payments from UK companies that are paid in US dollars. Special dividends have been announced by a variety of companies including Croda (in the chemicals sector,) ITV, Direct Line and Hiscox (in the nonlife insurance sector).

Be aware of the risks

When you invest your money is at risk.

After you buy a company its share price can crash or it could even go out of business. The stock market could also crash and all the shares you hold will fall at the same time.

But you can minimise the risks. Building a balanced portfolio of different stocks and investing across different sectors can minimise the impact from falls.