Best dividend shares: where to invest ahead of tax-free dividend allowance

Which are the best shares to invest in to take advantage of the new dividend allowance?

Investing in shares can pay off in two different ways for investors. Firstly, and most obviously, you want to see the value of your shares go up. However, the other potential benefit comes in the form of dividends. These are the regular payments that firms pay to their investors each year, and from next year those payments will become even juicier.

From 6 April 2016, investors will enjoy a new tax-free Dividend Allowance, which means that you pay no tax on the first £5,000 of dividends you receive from your investments, regardless of any other income you get. For dividends over £5,000, you will pay tax at these rates:

• 7.5% on dividends lying within the basic rate (20%) tax band;
• 32.5% on dividends within the higher rate (40%) band; and
• 38.1% on dividend income within the additional rate (45%) band.

This new system means that only shareholders with serious income from dividends will pay more tax. Indeed, the vast majority of British investors will either enjoy a tax cut or see no change in the amount of tax they owe.

Naturally, dividends received within tax-free ISAs and pension funds will remain exempt from tax.

Time to tweak your portfolio

With this new tax allowance arriving within six months, UK investors should start thinking about tweaking their portfolios soon, in order to make the most of this potential for additional tax-free income.

Indeed, some investors will already be seeking out UK shares that pay generous dividends, so as to maximise their use of this new £5,000 tax allowance. So which ones should you go for?

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Filtering the FTSE

Within the many members of the FTSE, there are 28 companies whose shares pay yearly dividends above 4%. However, several of the highest-yielding shares are of firms in weaker sectors (such as oil and gas, mining and supermarkets) that face serious earnings issues in the short term.

These include all five shares with the highest current dividend yields: miners Glencore (12.7% yield), Anglo American (12.5%) and BHP Billiton (9.4%), bank Standard Chartered (9.9%) and supermarket Morrisons (9.0%). With metals prices plunging to multi-year lows, a supermarket price war raging and conduct issues for Standard Chartered, these five dividends are almost sure to be cut, so don't make our shortlist.

Removing these five leaves 23 potential dividend candidates. To narrow down our search further, I raised the dividend hurdle to a yearly yield above 4.5%. This removes 10 more shares, leaving 13 from which to choose our regular cash payouts. Two of these shares belong to Royal Dutch Shell (its 'A' and 'B' shares), so we actually have just 12 firms to choose from.

Next, I removed all shares with price-earnings ratios (PERs) above 15, because I dislike paying over the odds for future corporate earnings. This flushed out another three shares, leaving nine in our pot.

Lastly, I removed four other businesses – supermarket Sainsbury's (5.3%), fund manager Aberdeen Asset Management (5.4%), miner Rio Tinto (6.3%) and house-builder Berkeley Group Holdings (5.9%) – all of which face future business challenges that I'd prefer to avoid.

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Five dividend dynamos

So with all of that filtering done, I've settled on five dividend dynamos. They all offer mouth-watering cash yields at a reasonable price. 

Source: Digital Look, share prices as at close on Wednesday 25 November

As you can see, we have a fairly decent spread of shares across market sectors, including oil production and exploration, power generation, publishing, banking and drug-making. That said, a portfolio of just five shares is by no means properly diversified; a decent spread of funds would be across at least 20-30 companies.

To generate £5,000 in yearly dividends would require a total investment of roughly £77,000 into this mini-portfolio.

What's more, we don't seem to be obviously overpaying for this stream of dividend income. PERs for these shares range from 8.3 at RDS to 12.1 at Pearson, with an average PER of 11.4. That translates into an earnings yield of nearly 8.8% for our five-share portfolio. What this indicates is that, as a whole, our portfolio's dividends are covered roughly 135% by earnings, giving us some headroom against dividend cuts.

Disclosure: Cliff owns shares in GSK

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