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Dividend investing can yield income, but watch for traps

Nicki Bourlioufas  |  19 May 2017Text size  Decrease  Increase  |  

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Shareholders in Australia can benefit from the favourable tax treatment of dividend income and, as tax time nears, it's worth understanding how the system works.

But one expert warns that investing for dividend income and tax benefits alone can be dangerous, especially if you want to keep your capital intact, as investing in Telstra (ASX: TLS) or National Australia Bank (ASX: NAB) highlights, both of which are well down over the past 10 years.

Dividends paid to shareholders by Australian companies are taxed under a system known as imputation. That is, the tax which the company has already paid on its profit is imputed, or attributed, to its shareholders as franking credits attached to the dividends they receive.

These credits can then be used to reduce an investor's income tax or be received as a tax refund depending on their marginal tax rate.

The dividend imputation system is designed to stop the double taxation of company profits and it can make investing in companies that pay fully franked dividends tax-effective. That's especially so when an investor's marginal tax rate is less than the company tax rate of 30 per cent.

If, for example, a company pays a fully franked dividend of 70 cents from its after-tax income, an investor in that company would receive a franking credit of 30 cents. That is, the company has already paid 30 cents of the tax obligation.

At tax time, the investor would need to declare $1.00 as taxable income, that is, the 70 cents dividend payment plus the 30 cents franking credit.

If the investor's marginal tax rate was 19 per cent (as their taxable income is less than $37,000), they would pay 19 cents tax on that income, and would be returned 11 cents from the franking credit in their tax return, and their total after-tax dividend income would be 81 cents.

If the investor doesn't pay income tax at all as they earn less than $18,201, or they are a self-managed superannuation fund in the pension phase, then they would get the full 30 cents credit back, says financial adviser Bruce Brammall.

"That is, the ATO will fully refund the full amount of the franking credit or 30 cents, so the dividend income after tax would be $1.00," says Brammall.

"But if the investor sits in a higher tax bracket than the company rate, he or she won't get a refund of any of the franking credit and will need to pay additional tax over that which the company has already paid.

"So, shareholders on the lowest marginal tax rate benefit the most from franking."

Given this, there are some things you can do to maximise your tax situation. Couples, for example, on different tax rates may wish to buy shares in the name of the person who enjoys the lowest marginal tax rate to maximise the refund of franking credits, according to stock research house Skaffold.

"Likewise, a retiree with a tax-exempt pension income can use the refund of the franking credits to supplement their pension income. Franking credits also represent money in the bank to self-managed super funds (SMSF) that pay a tax rate of 15 per cent," it says.

"The first thing is to seek dividends that are fully franked. The fact is, not all companies pay full franking credits. When companies pay less than 30 per cent tax on their earnings, for example, due either to a tax break or a previous year's losses carried forward, their dividends or other distributions will have both franked and unfranked components."

However, while investing in companies that pay fully franked dividends can be an effective taxation strategy, that alone should not guide a person's investment decisions, says Brammall.

"A company, for example, that falls in price from $20 to $10 and originally paid a 5 per cent dividend, the dividend yield would become 10 per cent. So, there's a reason for that high yield, and very often it's because the share price has fallen considerably. You also need to remember the dividend yield is generally historical and can be cut back at any time," he says.

"So, buying companies which pay high dividend yields can be a trap. Telstra is a good example of this. Many analysts are warning that Telstra won't be able to keep paying high dividends and its price has fallen because its high dividend payout is arguably not sustainable."

So, tax should never be the primary determinant of a decision to buy shares. The after-tax situation needs to be fully considered against other investment and wealth-building opportunities, says Brammall.

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Nicki Bourlioufas is a Morningstar contributor. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.

© 2017 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.