Money & policy

The dividend trap: why the highest yields in the FTSE 100 are the ones most likely to cost you

The Bill & Budget desk  ·  2026-07-13  ·  7 min read

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Here is the trap, and it is not about tax at all. It is about the first number you see.

Open any broker's screener and sort by yield. The top of that list is 8%. That figure lands first, and everything you look at afterwards is judged against it. A 10-year gilt paying 4.9% now reads as a disappointment rather than a benchmark. A tracker fund looks timid. The 8% has become the number the others have to beat, and you have stopped asking the only question that would have saved you: how often does a company yielding double the government's own borrowing rate actually keep paying it? The market is not offering you 8% because it likes you. A yield that high usually means the share price has already fallen, and the people who follow that company most closely are not betting the payout survives. Historically, yields far above the risk-free rate have been a warning about the dividend, not a gift.

Daniel Kahneman and Amos Tversky called this anchoring, and it is the reason a screener sorted by yield is one of the more expensive buttons in retail investing. The first number sets the scale, and every judgement afterwards is made relative to a figure you did not choose and should not trust. You compared 8% to 4.9% and saw a chasm. The comparison that mattered was 5.1% to 4.9%, and it is almost nothing.

The tax is what turns a bad bet into a worse one. Dividend income sits on top of your other earnings. If your salary puts you in the higher-rate band — £50,270 to £125,140 — every pound of dividend income above the £500 allowance is taxed at 35.75%. Cross £125,140 and the rate climbs to 39.35%.

Then there is the trap underneath the trap, and it is worth being precise about it. The dividend itself is taxed at 35.75%. That is the direct cost, and it is the one people budget for. What they do not budget for is that dividend income counts towards adjusted net income — so a payout that carries you past £100,000 starts dismantling the £12,570 Personal Allowance that was protecting your SALARY. You lose £1 of it for every £2 you are over, and it is gone entirely by £125,140. The dividend is taxed once directly, and then it strips away tax-free allowance that was sheltering money it has nothing to do with. Two costs, one payout — and only the first appears on any yield table. You are leaking money faster than a British Leyland radiator.

AJ Bell's research, reported by Which?, puts 53% of that forecast £88.8bn payout in the hands of just ten companies — HSBC, Shell, British American Tobacco and their peers. Concentration is only half the problem. The highest yields on offer — Investec at 8.5%, Legal & General at 8.1%, Standard Life at 7.3% — all sit well above that 4.9% gilt. Chasing them without checking the tax consequence is like queuing for a Take That reunion ticket: the headline act looks great until you see the service charge.

The shelter is not complicated. You have a £20,000 ISA allowance each tax year, and every pound of dividend income earned inside a stocks and shares ISA is free of income tax. Forever. No allowance cap. No higher-rate surcharge. No Personal Allowance taper. A £20,000 portfolio yielding 5% generates £1,000 a year. Outside the wrapper, the first £500 is covered by the dividend allowance and the remaining £500 is taxed — at 35.75% for a higher-rate payer, which is £178.75 gone. Inside the wrapper, none of it is taxed and the allowance stays intact for dividends held elsewhere. Over a decade, that gap compounds into thousands.

Inflation does not care about your tax bill either. Your spending power erodes whether the money goes to HMRC or not. A fixed-rate savings account guarantees the nominal return, but after tax and inflation the real return is often negative. Equities have historically beaten inflation over the long run — but only if you keep enough of the return to let compounding do its work.

Here is your five-step framework for the 2025-26 tax year. Do them in order.

1. Check your total dividend income against the £500 tax-free dividend allowance. Log into your investment platform, download the tax summary, and add up every distribution. If the total exceeds £500 you have a liability, and you must report it to HMRC through Self Assessment — the return for this tax year is due by 31 January, and the liability does not go away because nobody has asked you for it yet.

2. Move any new dividend-generating investments into a stocks and shares ISA and use the £20,000 annual allowance. You cannot transfer existing shares straight in: you have to sell and repurchase inside the wrapper — "bed and ISA" — which can trigger capital gains tax and dealing costs, so check both before you act. But every new pound should go into the wrapper first.

3. Work out your adjusted net income and compare it to the £100,000 threshold where the Personal Allowance starts to taper. Add up your salary, bonuses, rental profit and dividend income — then SUBTRACT your gross pension contributions and any Gift Aid. Those reliefs pull the figure DOWN, which is the whole point: a pension contribution made before the tax year ends can carry you back under £100,000 and rescue the allowance you were about to lose. You give up £1 of the £12,570 allowance for every £2 you are over, so the money in that band costs you far more than its headline rate suggests. Check the direction of that sum carefully — adding your pension contributions instead of subtracting them is the easiest way to talk yourself into a tax bill you did not owe.

4. Before you open a screener, write down the premium you require over the 4.9% gilt — the extra return that would justify the risk of the payout being cut. Decide it in advance, on paper, while no number is looking at you. Then compare any high yield against that figure, not against the one at the top of the list. If a FTSE 100 name yields 8% while the government pays 4.9% to borrow, the market is telling you something about the risk. Read the annual report. Check the payout ratio. Look at free cash flow coverage. If the numbers do not stack up, the yield is a warning, not an opportunity.

5. Declare it properly. Dividend income above the allowance is reported through Self Assessment, not collected automatically through your payslip — the return for this tax year is due by 31 January. If you are already in PAYE, HMRC may instead adjust your tax code to collect it, so check your code reflects what you actually owe. The liability does not disappear because nobody has asked you for it.

The stakes are simple. Ignore the £500 allowance and the taper above £100,000, and a higher-rate investor hands over close to 40p of every pound of dividend income. That is not investing. That is subsidising the Exchequer with your retirement.

The 8% at the top of the screen was never the offer. After tax it was 5.1%, the gilt was 4.9%, and the difference between them was the entire reason you took the risk.

This article is general information about UK personal finance, not financial advice. Figures are accurate as of the date shown and may change. Always check the primary source before acting.