While investors often focus on share price rises, it is dividends that can really drive long-term returns.
Harnessing the power of dividends can make your money work harder – and if you do it in a stocks and shares Isa then your returns can grow tax-free.
Dividends are payments companies make to shareholders to reward them, with an amount paid out for each share held.
Not all companies pay dividends but holding some that do as part of your portfolio can be a way to grow your wealth without relying on stock market movements.
By reinvesting dividends to buy more shares, you can take advantage of compounded returns but it’s important to avoid losing some of your company payouts to tax.
Since the start of the new tax year on 6 April, the dividend tax rate has risen to 35.75 per cent for higher rate taxpayers. On a share yielding 5 per cent, this tax hit would cut the effective yield to 3.21 per cent.
For a higher rate taxpayer investing £20,000 into that stock, this would make a £358 difference between receiving £1,000 in pre-tax dividends and £642 after tax.
But if they invested via a stocks and shares Isa, there would be no tax to pay.
We explain what you need to know about dividends and highlight seven ways to take advantage.
Dividend payments reinvested and compounded over the years can make a real difference to investment returns
Why dividends and compounding matter
Companies pay dividends to pass on earnings to shareholders and encourage investors to hold their stock.
In the UK, payouts usually arrive twice a year, but some companies pay dividends once a year or quarterly, and a few investment trusts and ETFs pay them monthly.
The dividend amount per share is set by a company when it releases results. The amount paid out compared to the share price is known as the dividend yield. So, a company paying out a dividend of 5p annually with a 100p share price, would have a 5 per cent dividend yield.
Investors can choose to either take the cash or reinvest the money. Doing the latter, means that over the long term you can really benefit from compounding – earning returns on existing returns.
If you reinvest dividends into buying more shares, you steadily build your holding – and a snowball effect means you subsequently earn larger dividend payments thanks to holding more shares.
This reinvested income can create a powerful compounding effect.
The Barclays Equity Gilt Study shows if you had invested £100 in the UK stock market in 1945, by the end of 2024 it would have risen to £326,231 with dividends reinvested – compared to £11,570 from the gain in share prices without compounding dividends.
Dividend payout amounts are also often raised by companies over time, delivering an extra growth effect.
Companies can cut dividends or axe payouts altogether in difficult times, although some have long histories of protecting them. A dividend cut can be due to company specific circumstances or due to broader problems, for example widespread cuts during the financial crisis and Covid pandemic.
Dividend tax and why you need to use an Isa
Dividends are taxed at rates that depend on your income tax band.
The current dividend tax rates are 8.75 per cent for basic rate taxpayers, 33.75 per cent for higher rate taxpayers and 39.35 per cent for additional rate taxpayers.
But these are due to rise from April 2026, to 10.75 per cent for basic rate taxpayers and 35.75 per cent for higher rate taxpayers. The additional rate will remain the same.
The tax-free dividend allowance has also been substantially reduced in recent years. It has gone from £5,000 in 2016, to £2,000 in 2022, and is now just £500 allowance.
This makes Isa investing all the more important. If you invest through a stocks and shares Isa there is no tax on dividends, meaning your returns can grow without the taxman taking a big chunk.
How to find reliable dividends
There are a number of things to look out for when assessing dividend stocks for reliability.
The obvious starting point is dividend yield. It can be tempting to just go for the highest yielding stocks, but you need to beware companies where bumper yields have been caused by their share price falling substantially, due to problems with the business or sector.
Very high yields can be a sign of trouble and that a cut is on the way – these stocks are known as ‘dividend traps’.
Digging deeper, it therefore pays to look at the financial health of the company, in terms of its revenue, profits and financial position, such as whether it has large debts or cash in the bank.
You should also look at a company’s dividend history. Does it have a track record of consistently paying out dividends or has it frequently cut them in the past.
Dividend growth also matters. Companies with a commitment to making and increasing payouts over time can be an important asset for income investors. A steady series of dividend increases means that in the future, shares bought in the past can yield considerably more than when they were purchased.
A company that pays a 6p per share dividend and raises that by 5 per cent a year for ten years would end up paying a 10p per share dividend.
Two key metrics to look for are the payout ratio and dividend cover.
The payout ratio is the percentage of a company’s profits being handed over in dividends and helps you understand how much is targeted towards growth and what goes to rewarding investors with income. To find this out divide the company’s total dividends paid by its net income and multiply by 100 to get a percentage.
Dividend cover is earnings per share divided by dividends per share. This shows how well the company’s profits have the payouts covered. The higher the number the better.
BP is one of the FTSE 100’s big-yielding stocks and a stalwart for income investors
Seven shares and ETFs for dividend income
City of London – 4.01%
City of London investment trust is what’s known as a Dividend Hero. These are the investment trusts that have raised payouts to investors for at least 20 years in a row. The Association of Investment Companies most recent report put City of London top of the pile with an astonishing 59 years of successive dividend rises. It holds largely UK companies, tilted towards large caps, including HSBC, Shell, Unilever and NatWest.
Vanguard FTSE 100 – 3.09%
Vanguard’s ETF offers a passive way to pick up income from the FTSE 100 and also hopefully profit from share price rises. It holds firms in the same market cap weighted proportion they appear in the leading UK stock market index and has low ongoing charges of 0.06 per cent. Pick the distribution version if you want dividends paid out, or the accumulation version to have them roll up and compound.
Vanguard FTSE All-World High Dividend – 3.24%
Vanguard’s FTSE All-World High Dividend ETF broadens investors horizons to track high yield company shares around the world. It holds more than 2,200 stocks and the largest weighting at 39 per cent is to the US market. A decent yield is on offer, and it has ongoing charges of 0.29 per cent.
Legal & General – 8.72 per cent
Financial and insurance giant L&G has a bumper yield of 8.72 per cent thanks to a policy of growing dividends, strong cash flow and its shares trading at a relatively low level. The share price is 13 per cent down on five years ago.
BP – 4.06%
BP has seen its shares shoot up as the oil price has spiked due to the Iran war but still has a healthy dividend yield. Rival Shell has been considered the better investment for the past few years due to BP’s management and strategy struggles, but it only currently yields 3.02 per cent.
Coca-Cola is known as a dividend king, with 50 years of raising payouts
Coca-Cola – 2.71%
Coca-Cola’s yield may seem modest by UK standards but is healthy for the US, where dividends tend to be lower. It is known as a dividend king, companies that have raised payouts for at last 50 years – and can go considerably better than that with a 64-year record of raising dividends. Be aware that buying US stocks opens you up to currency movements that can shift actual returns from share price movements and dividends.
Realty Income – 5.28%
Realty Income is an interesting US property stock with a high yield. The real estate investment trust (Reit) is known as the ‘monthly dividend company’, as it pays income each month and is dubbed a Dividend Aristocrat thanks to its 31 years of raising payouts.
Yields correct at 31 March 2026
When investing, your capital is at risk and you may get back less than invested. Past performance doesn’t guarantee future results. Other fees may apply. See terms and fees. Tax treatment depends on your individual circumstances and regulations which may change. This information is not investment advice. Do your own research.