How to Invest: What is a Stock Dividend?

what is a stock dividend

Investing in the share market can be the most passive way to create income. You may be wondering what is a stock dividend and how franking credits work. Before you start investing, you should have a general wealth building strategy.

When you invest in the stock market, you can make money through dividends or capital gains.

What are Capital Gains?

Capital gains means the increase in the value of the stock, index fund, managed fund or LIC.

The value of investments listed on the stock exchange bounce up and down all the time, but over time the general trend is upwards.

If you buy a stock for $1 and over 30 years the price of that stock increases to $4, your capital gain (per stock) is $3. Any amounts of gains can be made without incurring tax, until the asset is sold. Capital gains are discounted by 50% if the asset has been held for at least 12 months.

What is a Stock Dividend?

The other way you can make money through the share market, is by earning dividends.

When the company produces a profit, the companies can use this to reinvest to grow the business.

Fast growing companies will want to use their profits to expand and create more profits the long-term. Young companies may not pay a dividend, if they wish to invest in growing the business. Berkshire Hathaway does not pay out a dividend because Warren Buffet is confident he can reinvest profits for further growth.

If a company cannot utilise the profits effectively for growth, they can pay out the profits to share holders as a dividend. Larger, more established businesses often produce profits well above the amount they can effectively reinvest in the business. These tend to be dividend paying stocks.

Some investors are very focussed on dividend paying stocks. They aim to gradually grow a passive income through dividend income. As a result, these investors like to buy large, stable stock that consistently pay a dividend, that increases over time.

Dividends are taxed at your marginal rate. Franking credits, can however, generously reduce tax payable.

 

What is a Stock Dividend: Are Dividends a Legal Requirement?

Not all companies pay dividends, and even those that do are not obliged to continue. During the Global financial crisis, many companies stopped paying, or drastically slashed dividends.

Many investors love the idea of dividend investing as a way to gradually grow income over time, without making withdrawals. But dividends cannot be relied upon. In the event of a stock market crash, dividends may dry up and need to plan for this eventuality.

Are Dividend Payments Taxable?

Dividends are taxed as regular income, at your marginal rate. For many readers that will incur 45% tax. This can obviously eat into your returns in a dramatic way.

Australia is quite generous with investors though and offer Franking credits (aka imputation credits) on your franking credits. The business you own a share in pays tax on profits at the business rate (30%). If your dividend pay out is then taxed, the profits are effectively taxed twice.

Franking credits aim to avoid double taxation.

ATO

When you receive a dividend, the ATO will take into account the 30% tax already paid by the business. If the investor is on a marginal rate of less than 30%, they will receive a refund for excess tax paid. If on a marginal rate of more than 30%, the investor will only pay the difference between 30% and marginal rate (so an extra 15% for those on the top bracket).

Sometimes businesses have not had to pay tax on income, there will be no franking credit attached to this part of your dividend. Some dividends are “fully franked”, others are “partially franked” for this reason.

How Are Franking Credits Calculated?

Company A makes $100 profit per share.

They are taxed at the corporate rate of 30% on that profit.

They pay out the remainder as a dividend to shareholders = $70

 

Shareholder Sam on 0% tax bracket (Non-earning spouse) receives $70 dividend and declares at tax time

ATO “Gross up” original profit to $100

Then tax at marginal rate – 0% tax owed

Then deduct tax credit for tax already paid = -$30

Shareholder Sam receives $30 tax refund. Cha-ching!

Lets examine the same situation for Shareholder Sally on the top marginal rate of 45%

Company A makes $100 profit per share.

They are taxed at the corporate rate of 30% on that profit.

They pay out the remainder as a dividend to shareholders = $70

Shareholder Sam on 45% tax bracket (Non-earning spouse) receives $70 dividend and declares at tax time

ATO “Gross up” original profit to $100

Then tax at marginal rate – 45% tax owed = $45

Then deduct tax credit for tax already paid = -$30

Shareholder Sally owes the ATO $15 (well it is better than $45)

Are Dividend Reinvestments Taxable

Dividends, whether they are reinvested or not, are taxed at your marginal rate. If you want to reinvest your dividends, brokerage fees need to be paid again.

Dividend reinvestment plans allow automated reinvestment of the dividend into the same asset. This saves on brokerage, and takes advantage of the powerful effect of automation, removing temptation to spend investment income. If a dividend reinvestment plan (DRP) is available, this option will be offered when by the share registry after asset purchase.

However, dividends that are reinvested are still taxable. As you have not actually received then income, you need to pay tax out of your own pocket.

Dividend substitution plans (DSSP) are advertised as allowing you to delay paying tax on dividends. In these plans, the company (AFI or Whitefield) reward investors by giving them bonus shares in lieu of cash dividends.

This avoids taxation and brokerage. Instead of being taxed (and claiming franking credits) each year, the value remains invested to continue compounding for many years. When you eventually withdraw your earnings, this will be taxed as a capital gain.

DSSP can be advantageous for high income earners (and high tax payers), particularly if they will be on a lower tax bracket at time of withdrawal.

DRP is generally advantageous for low income earners (and <30% tax payers) that will receive franking credits.

 

Do Dividend Pay Outs Affect the Stock Price?

Stock prices tend to drop after the ex-dividend date. The ex-dividend date is the day after which new stock purchasers will not be eligible for the next dividend. This is probably not relevant to long-term investors.

The stock price dropping when a dividend is paid out prompts me to wonder what the difference is between a dividend pay out and equivalent withdrawal?

Dividend Yield

Dividend yield is the annual dividend total divided by the price of the share. This is important to investors seeking dividend income, but irrelevant to those looking only to maximise total return.

Tax time

Further information on dividend taxation is available at the ATO. Your broker should provide an end of year statement to take to your accountant at tax time, or Sharesight will provide a statement if you have linked your account.

Dividends vs Capital Growth

Investors seem to be divided in this. I can see the appeal of dividend income for low income earners (up to a point), but see total return as my goal overall.

With a generous income currently, I don’t need a few hundred dollars a year in dividend income, and certainly don’t want to pay tax on income I don’t actually need.

I would prefer to receive all growth in capital gains (at least until I am closer to retirement!). The longer I can delay taxation, the longer the untaxed growth has to compound. Capital gains are discounted 50% when I finally withdraw, when I expect to be in a lower tax bracket.

What is a Stock Dividend: Conclusion

A stock dividend is a way for the company to share profits with shareholders.

Not all companies give out dividends. Those that do should be 1. Making a profit and 2. Unable to use the profits to invest back into growth effectively.

Companies that traditionally have paid dividends will not necessarily continue to do so (particularly if there is an economic downturn).

Higher income earners should not chase dividends, it is more efficient to delay income and taxation until it is required.

Aussie Doc Freedom is not a financial adviser and does need offer any advise.  Information on this website is purely a description of my experiences and learning.  Please check with your independent financial adviser or accountant before making any changes.

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