In Australia, we have a somewhat unusual sharemarket, economy and tax system. All of which make for some interesting discussion around investing.
If you’ve even glanced at this blog, you’ll know I believe in investing for a growing income stream.
Investments which can grow alongside us throughout our lives and provide us with increasing amounts of cashflow.
But as sexy as that sounds, there’s a nasty side to this ‘heaven on earth’ mental image…
Yes, that necessary evil side-effect of making money. One of the first arguments that comes up when talking about investing for income, is tax.
Clearly, dividends are a form of income and therefore, subject to tax. So the assumption is, dividend growth investing is not a very efficient way to invest.
There’s a number of ways we can take this topic. One of those being, the mass hatred of paying tax and the unrivalled fetish for tax deductions.
But today, we’ll just focus on what matters most to us – how tax affects our investment returns and specifically, our journey to financial independence. Hint: For dividend investors, the tax bogeyman is not nearly as bad as it’s made out to be.
Remember, the people often complaining about tax on investments, are often the same ones complaining about paying tax on their salary. The best way to educate these people is this…
You want to pay less tax? Easy. Just make less money. Offer to take a pay-cut. Or get a lower-paying job.
What, that’s not appealing? Then suck it up! And let’s learn how to make more money and optimise things, rather than having a moan about it!
For simplicity’s sake, calculations in this article will be based on using Listed Investment Companies (LICs) for an investment journey. If you’re just beginning investing, you have a few options.
The first thing to consider for couples is, which spouse will have the lowest taxable income throughout your journey. It makes sense to invest more heavily in this spouse’s name, as less tax needs to be paid on dividend income.
In fact, a couple with a spouse earning under $37,000 per year, will be entitled to a franking credit refund (under current rules). This is because their tax rate is 19%, much lower than the franking rate of 30%.
OK, what if you’re single, or a couple both earning more than $37k?
Dividend Substitution Share Plan (DSSP) and Bonus Share Plan (BSP)
Before your eyes glaze over or you choke on your coffee and say ‘what the hell is he talking about’, just bear with me.
This stuff may well save you a ton of money, and/or earn you higher investment returns due to tax savings, so try to take it in.
What is a Dividend Substitution Share Plan (DSSP)?
Well, essentially, this is a plan offered by AFIC – our largest investment company – which allows you to forgo your dividend and receive extra shares instead.
You are substituting your dividend, for additional shares. (I mentioned it in my review of AFIC here)
Wait, isn’t that the same as a Dividend Reinvestment Plan (DRP)?
No. It’s very different.
With a DRP, you receive extra shares instead of your dividend, but you need to declare that amount as income and pay tax on it. You also get to use franking credits to offset your tax. But in the eyes of the ATO, you’ve still earned that income and tax needs to be paid.
In the case of a Dividend Substitution Share Plan (DSSP), AFIC has a special ruling from the ATO, where you can receive these additional shares and no income needs to be declared.
And it’s fully legit! You can check out the documents and ruling on AFIC’s website here.
Wait, no tax, what’s the catch?
The catch is, you also don’t get the benefit of franking credits. So this means, it doesn’t make sense unless you’re on a tax rate of over 30%. This is the break-even point.
Because in a normal situation, you only need to pay the difference between your tax rate and 30% (the value of the franking credit).
Currently, if you’re on a higher bracket, you’ll owe tax, if you’re under 30%, you’ll get a refund.
Since the average Aussie earns a pretty solid full-time wage, they’re comfortably bumped into the 30% and above brackets. More on the ‘catch’ later.
So what’s a Bonus Share Plan (BSP)?
It’s really the same thing as the DSSP discussed above as offered by AFIC. But just a different name for it.
This Bonus Share Plan (BSP) is offered by another investment company – Whitefield.
And Whitefield also has a special ruling from the ATO, in which you’re allowed to participate and receive ‘bonus’ shares instead of a dividend and franking. You can find some info on their website here.
OK, so is it a good idea?
Many people are wondering what kind of a difference it can make to investment returns. In simple terms, using the DSSP/BSP schemes are simply a way to limit tax on your investment earnings to 30%.
For investors on a tax rate of 32.5% (income of $90k or less) it’ll make a small difference. If you’re on a tax rate higher than that, it can have a huge impact.
Remember, if you’re on a tax rate of 32.5% or less, your tax is essentially fully covered by your franking credits anyway! So you already have it pretty good!
If you’re not sure which tax bracket you’re in, check out this page.
Let’s run a scenario for a high-income earner. This person probably assumed dividend investing was a terrible idea, as they’d be left with little return after paying tax.
So let’s see how the numbers shake out using these DSSP / BSP things…
Income investing for high-earners
Some numbers and assumptions to start:
— Our investor purchases shares in either AFIC or Whitefield (or both) to utilise these dividend substitution plans.
— These LICs have a dividend yield of 4% fully franked. This equates to 5.7% grossed-up to include franking.
— Dividend growth and portfolio value grow at the same rate – 3% per annum. This gives us a total return of 7% per annum, plus franking. (Dividend Yield + Dividend Growth = Total Return)
— Our high-earner is on a tax-rate of 47%.
Usually, this investor would be left with a 3% net yield after tax. (5.7% gross, less 47% tax, equals 3% net)
So based on the initial 4% dividend, they lost 1% to tax – franking covered the rest. Once we add in growth, the investor is left with a 6% after-tax total return, to compound over the years.
But by utilising these Bonus Share Plans, our investor can instead receive 4% more shares, rather than a 4% taxable dividend with franking. And those 4% bonus shares aren’t classed as income, so there’s no tax payable.
The result? Our high-earner now earns a 7% after-tax total return, rather than 6%. Now let’s take a look at how this affects his wealth accumulation.
DSSP / BSP vs 47% tax rate
Here’s how the savings look in chart form. This chart measures our investor adding $50k per year to his portfolio.
One line is copping the 47% tax rate on the chin. The other is using the DSSP / BSP offered by AFIC and Whitefield.
I know what you’re thinking, “Wow big deal”. Now, I’ll admit, those lines are pretty damn close to each other.
But believe it or not, this resulted in a difference of about $93,000. Yep, almost a hundred grand!
Now I don’t know about you, but that’s a shitload of money to me!
Here’s the final figures: Investing normally, the end balance after 15 years is $1,163,000. Not bad for an eye-watering tax-bracket!
Investing using the DSSP / BSP resulted in a final balance of $1,256,000.
Taking it to the next logical conclusion…
This means our high-tax investor would have finished with a portfolio spitting out $46,520 in dividends (plus franking) under the first scenario.
But using the dividend substitution plans, his larger portfolio would be throwing off $50,240 (plus franking) in cashflow. A difference in yearly income of around $4,000. Certainly nothing to sneeze at!
By the way, as with most short journeys to financial independence, the result was driven more by saving than investing. As we’ve covered before, saving is where you should focus.
What if your tax bracket is 37%?
Your tax savings would amount to around $40,000 over 15 years. Quite a bit less, but still worth considering.
Your final balance would, of course, still amount to $1,256,000, using the DSSP / BSP. But if you invested normally and copped the tax, you’d end up with $1,218,000.
In case you’re wondering, your return becomes 6.6% per annum, versus 7% with the BSP. So tax chewed up 0.4% per annum of your return.
Before you get all Scrooge McDuck and start daydreaming of swimming in your tax savings, we need to cover the downsides…
How to use the Dividend Substitution/Bonus Share Plans
You can simply fill out a form and send it back to the share registry to participate in these plans (just like the DRP). But because nothing is free, there’s a few conditions that come with these plans.
The major issue is Capital Gains Tax. If you sell any of your holding, you’ll be up for a larger than normal amount of CGT. Why?
Well, say you own 1000 shares of AFIC. You elect to participate in the DSSP. One year later you have 1040 shares of AFIC. The company paid you 4% ‘bonus shares’ rather than a 4% dividend. These shares cost you $0.
Let’s say your original parcel of 1000 shares cost you $6000, or $6 per share.
Well, now you have 1040 shares, but your cost basis is still $6000. This means for tax purposes your average cost is now $5.77 per share.
See what’s happening here?
Your cost basis is going down because you’re getting these shares at zero cost. So it’s adding to your future potential Capital Gains Tax. Holy crap, that’s bad right?
Well not necessarily. Here’s the optimal way these plans are used…
The Happy Accumulator
Suppose you’re earning a decent income and you’re in the 37% bracket or higher. You could start buying shares in AFIC or Whitefield and elect to participate in these Bonus Share Plans.
Along the course of your road to financial independence, you’ll pay no tax on your dividend income. Your investments will simply compound by themselves and you continue buying more whenever you can.
10-15 years later, your share accumulation hits critical mass. You simply elect to start receiving the cash dividends, plus franking credits, at any point you like, once you believe it’s enough income to cover your expenses.
You obviously never sell your shares, and it’s happy days. The extra CGT owing makes no difference if you never sell.
Essentially, this is a perfect scenario and what these plans were designed for, tax-efficient share accumulation. Of course, the real world is often not that simple. Sometimes things happen or life gets in the way.
In my opinion, these plans are best suited for those paying at least 37% or more in tax, and then only when you’ve considered your own situation carefully.
Yes, you’ll save some tax if you’re in the 32% bracket. But I’m not sure it’s worth it. I probably wouldn’t bother as the savings will be quite small and these plans come at the cost of flexibility.
Personally, I’ve never used the DSSP or BSP because we’re now in a low-tax, early retirement scenario. And in any case, I was too sidetracked investing in property to notice the wonders of dividend investing in the earlier stages of my journey.
But if I was starting today and paying 37% tax or more, I’d most likely go this route and invest in AFIC and Whitefield. It’s pretty easy to say you’ll never sell. But doing it is another matter.
Although not optimal, you could be forced to sell shares if you need to fund a big unexpected expense. Or because of job loss.
You may decide you don’t like LICs anymore and you’d rather invest in index funds. Or, you want to decrease your exposure to Aussie shares because you’re worried about a recession.
At the end of the day, if you think you might sell at some point, really weigh each side before diving in. It’s not set in stone either. You can turn it on or off at any time.
If you fall into a lower tax bracket for a while, you can simply choose to start getting your dividends and franking again.
Alternatively, if you find yourself in a high-tax environment for a while, you can use these plans to optimise your tax for as long as you need.
A fellow blogger also recently wrote about DSSP’s which you might find more concise and helpful than this post!
Companies and Trusts
First, I’ll just say this area is not one I know a lot about. I just don’t feel our situation requires these types of structures. So please take this section with a grain of salt!
Other options to reduce tax and therefore increase your investment returns are owning shares via companies and trusts.
A commonly used one is the Discretionary Trust. Often used by a couple for investing. This can be used to hold investments and distribute certain amounts of income to whoever is in the lowest tax environment.
But once both spouses are paying more than 30% tax, there is often a next step taken. The creation of a ‘bucket company’.
This is where any excess earnings are distributed to the company which pays 30% tax. But the company misses out on the CGT deduction that individuals get.
The result is a maximum tax rate of 30% and flexibility over where to distribute capital gains and income each year to optimise the result.
Keep in mind, these setups create more admin and complexity. Also, they aren’t cheap. You’ll need to see accountants and/or advisers to nail down the best fit for your own situation. And these added costs can really diminish the benefits.
Tax Efficient Dividend Investing
After going through these scenarios, we’ve covered the entire tax spectrum. And it seems to me, there’s not a lot of reasons we should be paying much more than 30% tax on our dividend income.
Once you account for franking, there’s little if any tax to pay. So I ask, how are dividends in Australia inefficient?
This means the 4% yield you see on these LICs we discuss, is pretty close to the yield you should be getting, after tax.
And of course there’s no expenses to go with that, unlike property for example.
So despite the cries of some pointing at the tax consequences by investing for an income stream, the real outcomes are quite benign.
With a 4% net yield, and adding earnings growth in line with the economy of 3-4% per annum, you’re looking at 7-8% per annum return, after tax. And this is while being an income-focused investor.
In retirement, under current rules, it’s even sweeter. Because of franking credit refunds, that yield climbs to anywhere up to 5.7% after-tax, depending on your own tax bracket of course.
Now, whether franking refunds continue is another topic altogether. But even if they don’t, we’re still back in the enjoyable position of 4% net yield and an expected return of 7-8% after-tax.
Try this on for size…
Even if franking refunds are squashed, franking credits still remain. This means you still get the benefit to offset your tax, just like you have since 1987.
And although it’s no certainty, even the tax-happy Labor party has said the initial franking credit imputation system will remain as it was first established.
In retirement, this means you can earn fully franked dividends of $95k per year and pay no tax. Here’s how…
$95k of fully-franked dividends comes with $40k of franking credits. This gives you a grossed-up income of $135k.
For tax purposes, you pay tax on $135k of income. But you’re also entitled to the $40k of franking credits to offset your tax.
And funnily enough, the tax payable on $135k of income, is $40k. See here.
This means the franking credits pay your tax entirely, leaving you with $95k of cashflow free and clear. No out of pocket tax.
You can double this amount for a couple that holds the shares equally. So that’s $190k of dividends, with franking credits covering the tax bill.
If you’re wondering, a portfolio worth $4.75 million split between two people, producing 4% fully franked dividends would produce this level of income. That’s a fairly massive portfolio and a pretty good outcome.
These folks are still clearing 4% net yield after tax. Again, where’s the inefficiency?
And these tax-friendly scenarios will likely improve over the coming decade as both political parties look keen to cut personal tax rates, or increase the tax brackets.
As the above articles explain, these tax issues aren’t the reason for my investment approach. But they’re a benefit that I’ll happily tap into for as long as they’re available.
Going over the numbers, these are my takeaways:
On the way to, and during early retirement, this style of investing is very effective…
— For low income earners, dividend investing is incredibly favourable, with no tax to pay and even franking credit refunds boosting your after-tax income.
— For middle income earners, dividend investing is reasonably efficient as there’s no out of pocket tax to pay and you can compound your wealth unaffected by taxes.
— As discussed, for high income earners, there’s a number of ways to optimise your situation, including DSSP / Bonus Share Plans, so you’re paying little or no tax on your dividends.
— Finally, in retirement, there’s no out of pocket tax to pay until you reach a truly mammoth-sized portfolio.
Worst case scenario, you have to pay a small amount of tax as your income grows. There’s worse things I can think of than having a growing amount of cashflow from your investments each year!
So much for the terrible tax consequences of dividend investing. And before you start focusing more on saving tax than on making sensible investments, here’s what Warren Buffett has to say:
“In the meantime, maybe you’ll run into someone with a terrific investment idea, who won’t go forward with it because of the tax he would owe when it succeeds. Send him my way. Let me unburden him.”
By the way, I created an easy-to-use spreadsheet which I use to keep a running estimate of our annual passive income after every purchase. Click here to get it for yourself.