Investing for income: A beginner’s guide

Equities that pay dividends

Income tends to be above inflation and there is the potential for capital appreciation. The downside is that the capital value – the price of the share itself – can fall. Perhaps the greatest risk involved here is that you are exposed to the fortunes of a single company, a threat known in professional circles as stock-specific risk. It is also worth bearing in mind that equities with a high yield tend to be riskier and this is why they pay out more, so if a yield looks too good to be true, it probably is.


Income funds and trusts

"Compared with investing directly into an asset class, you are diversifying your investment," said Ben Willis of IFA group Whitechurch. "Also because you are pooling your money, you get access to avenues of investment that you might not be able to access if you are investing on your own."

In August, FE Trustnet examined the highest-yielding funds across a variety of sectors.


Fixed interest

"Bonds are a step down the ladder in terms of risk than equities. The riskier the bond, the more it will pay out," said Philip Haden, director at advisory firm McCarthy Taylor. "If the company goes bust, holders of bonds are higher up the pecking order in terms of a pay-out than holders of equities."

Anything above the BBB rating awarded by Moody’s and Standard and Poor’s is considered investment grade; anything below this has "junk" status. It is worth noting that investors do not have to pay capital gains tax on gilts.


Buy-to-let

"On the plus side, property prices have fallen, which means the rental yield has increased as a percentage of property prices," added Haden, describing the relationship between the price of a property and the rental yield that it pays out; the lower the former, the higher the latter in relative terms.

"Also, yields tend to be above inflation. Property isn’t correlated to other asset classes, and there is also a chance of capital appreciation on its value."

Investing in a property for buy-to-let purposes also has a number of drawbacks. Back in July, Nexus IFA’s Kerry Nelson explained why: "It [property] is the most illiquid asset class and if you need to get your money out quickly, you immediately become a distress seller."

"Property is also one of the least tax-efficient ways of investing, unless you can turn it into a business. You get taxed on your income and taxed on your returns in the form of capital gains tax. Also, there are no tax wrappers unless you invest in a property fund."


Cash

With a savings account, the first £85k is covered under the FSA’s compensation scheme. The downside is that currently, with CPI at 4.5 per cent and RPI at 5.2 per cent, the net return on cash won’t keep up with inflation.


Considerations

Investors who take a regular portion of income from their portfolio miss out on the effect of compound interest. This is comparable to putting a lump sum into a high-interest account and then withdrawing all the interest made on the account as soon as it is paid. Every time an interest payment is made, if you leave it in the account, you are adding to the amount of money upon which interest is payable – which can result in a significant impact.

In the book Investing by Glen Arnold, the author cites the Barclays Capital Equity Gilt Study 2009 to demonstrate the importance of re-investing dividends, writing: "If an investor had chosen to spend dividends received on a £100 investment made in 1900 as each year passed, rather than reinvest, by January 2009 capital gains alone take the fund to only £9,129 (nominal return). On the other hand, another investor who reinvested the dividends over the 109 years would have had a fund worth £1,152,944."

Automatically re-investing dividends also tends to be more tax efficient. If an investor takes their dividends, these are subject to income tax, which will be 50 per cent for those earning more than £150,000 a year.

If they automatically re-invest the dividends, they are subject only to capital gains tax when they sell their investment. This currently stands at between 18 and 28 per cent, depending on their total taxable income and gains.

There are many strategies designed to achieve returns that include a regular income, and this article only covers the most popular. If you have a suggestion for a strategy that isn’t included and that you’d like to read more about, contact Anthony.luzio@financialexpress.net to request a study.