When dividends land in your bank account, what do you do? Reinvest, splurge, or save? In this episode, we're breaking it all down: what dividends are, how to reinvest them and how they factor in your tax returns.

While we've covered some ground here, there's only so much we can fit into one podcast episode. This shortlist of in-depth articles will fill in the gaps:

• How are dividends paid?
• What does “ex dividend” mean?
• How do franked dividends work?
• How do I find high-dividend ETFs?
• What’s the difference between a dividend and distribution?
  

What are dividends?

When a company is doing well, it either reinvests the money into growing the business, or passes some of it to their shareholders. Many companies choose to share a portion of their earnings as dividends .

Think of dividends as a thank you note from the company. But, instead of a card, you get cash (or sometimes more shares). Understandably, many investors find dividends exciting because they provide the prospect of a stream of income.

Just to be clear, though: dividends aren't just a straightforward cash handout. There’s a bit of corporate decision-making behind whether, when, and how much is paid out. Companies aren’t obligated to pay dividends. But, when they do, it’s typically to signal financial stability and to satisfy their (or attract) shareholders.

Also, dividends are not exclusive to individual shares of companies. Exchange-traded funds, or ETFs, can also distribute them – just under a different term (which we’ll talk about in the next couple of sections). Since an ETF is essentially a basket of shares or assets, it collects dividends from these holdings. Then, it passes those dividends on to you (either in reinvestments or cash).

So, how do shares and ETFs actually make money?

With that said, successful shares and ETFs generally make money in two ways: dividends and capital growth.

Think of dividends as the rent you collect from a property you own. It's the regular income that comes your way, simply because you hold onto that asset. Every so often, the investment pays out a portion of its earnings right back to you. It's straightforward, and one of the perks of being an investor.

On the other hand, capital growth is the increase in value of your investment over a long time. For shares, this growth reflects in the share price. This price may climb as the company expands, innovates, or increases profitability. It's similar to a house whose value appreciates due to good market conditions or renovations.

Unlike dividends, though, capital growth is only realised when you decide to sell your asset. It’s the selling in the market that converts your paper gains into tangible cash.

Difference between dividends and distributions

When we talk about dividends, we're talking about the share of profits that companies distribute to their shareholders. In contrast, distributions are a bit broader. For starters, they’re not exclusive to companies; distributions can also come from managed funds, exchange-traded funds (ETFs), listed investment companies (LICs), and real estate investment trusts (REITs).

So, while all dividends are distributions, not all distributions are dividends. There’s a confusion between the two because it’s just easier to say "dividends" for everything. For instance, you might hear someone say they've received dividends from their ETFs. But, technically, they’re talking about distributions.

How to evaluate and compare high-dividend ETFs

First off, it’s tempting to put everything in high-dividend ETFs because of their historically impressive (but not guaranteed) payout. However, in investing, a focus on the big picture is what really shapes the results in the long run.

This means considering not just the dividend yield but also the total return, which includes capital growth and currency impacts. You also have to pay attention to expense ratios and what’s actually in the fund (assets or holdings).

For example, let’s look at a few funds as of June 2024. Let’s start with BetaShares Australian Top 20 Equity Yield Maximiser Fund (ASX:YMAX) ETF . At first glance, a 9.27% annual dividend growth over the past five years sounds impressive. Obviously, though, this isn’t the whole story. Despite the dividend growth, the annual growth of share price went negative at -1.94% on a five-year average. As a result, the total return (after fees) would be 7.33%.

To clarify, there are other metrics to consider (e.g., total returns and NAV) depending on your goals and timeline. But, typically, a high dividend doesn’t necessarily signal market-average returns (9-10% p.a.) in the long term.

In comparison, Vanguard Australian Shares High Yield (ASX:VHY) ETF might initially seem less attractive. This one had a lower annual dividend rate of 7.3% over five years. Yet, VHY managed total returns (after fees) of 10.67% p.a. at the same time. In the example above, a lower dividend rate doesn’t always mean a lesser deal.

Another example is the Vanguard Ethically Conscious International Shares Index (ASX:VESG) ETF . It reported a modest 2.4% dividend growth over five years, but climbed to 17.21% p.a. total returns (after fees) in that period.

All of these figures come from Sharesight, and span over a five year period.

Tools like Sharesight and Navexa can also give you a holistic picture of where your investments are at.

Arguably, dividends are not “free money”

This leads us to an important point about investing for dividends. According to a recent paper , it’s a common investing mistake to treat dividends and capital gains as completely separate returns. So, we tend to focus on one and ignore the effects on the other.

The reality is dividends aren’t really extra gains. It’s more like money being transferred from the share price to the dividends.

As we’ve mentioned, when a company pays out dividends, it’s sharing some of its profits (or assets) with you. But, as these dividends are paid out, the company's total value decreases by the amount of the dividend.

So, while you receive money, the value of your shares in the company often drops slightly. This balances out that “passive” income you get. In the end, you get to pocket your profits sooner than those who prefer capital growth over a long time. Hence, it’s worth considering this effect and how it fits with your overall objectives.

How to find out which investments pay dividends

All the info we shared about the ETFs above are usually available for public search. The quickest way is to Google the name of the investment along with "dividend yield”. If you want the specifics, you can directly visit the fund manager’s website and select any of the ETFs. Once there, head straight to the distribution section.

Sometimes, though, all the numbers and PDFs in the website can make it confusing to know where to look. Investing platforms like Pearler and InvestSMART can give a basic overview of the numbers you actually need to make decisions. Then again, we always recommend reaching out to a financial adviser whenever you’re in doubt.

How often are dividends paid?

Well, it largely depends on the company or ETF you are holding. The most typical schedule for receiving dividends is quarterly (four times a year). There are also companies and ETFs that pay dividends monthly, while others pay only twice or once a year.

This is why it’s crucial to swing by the company’s dividend payment schedule. A quick check can help you plan better, especially if you’re counting on dividends to cover your bills.

Dividend reinvestment plan (DRP)

If you’ve been researching the topic of dividends, you may have also seen Dividend Reinvestment Plans (DRP) come up.

Basically, DRPs let you automatically use your dividends to buy full shares of the company or ETF that paid them. Instead of receiving dividend payouts in cash, you get more shares. This happens automatically with each dividend payment.

And you’re right – like anything in finance and investing, DRPs come with their own set of pros and cons. Now, keep in mind that the rundown below is just to give you a feel for how things generally pan out. Every investor's situation is unique. And, while these insights can guide you, there’s no substitute for professional advice. If you’re thinking about diving into DRPs, think of this next bit as the start of your research.

Advantages

1. Potential discount

DRPs usually come with zero brokerage fees because your dividends don’t buy the shares from the open market. Sometimes, there’s a little discount on those shares too (depending on the company or brokerage firm).

2. “Set and forget” your investing

DRPs help you make a habit of investing regularly. Even if life gets busier, you’re still building your investments in the background.

3. Dollar-cost averaging

When you opt for a DRP, your dividends are automatically reinvested regardless of the price and market conditions. On one hand, it may not give you outsized returns in the long term. However, it can potentially smooth out the average cost of your investments. At the same time, you avoid the trap of timing the market and learning an expensive lesson.

Disadvantages

1. Tax considerations

Reinvested dividends are still taxable income. Even if that cash never lands in your bank account, the Australian Taxation Office (ATO) expects them on your tax return . So, you may have to set aside significant tax money if you’re reinvesting big amounts of dividends. It’s worth seeing a tax professional to seek advice on this.

2. Reduced cash flow

When dividends are reinvested through a DRP, you don't receive the cash in your bank account. Instead, the money is used to buy more of the share or ETF in question. It’s essentially a locked-in capital you can’t use to fund other financial needs or opportunities.

3. Concentration risk

Imagine you've invested in a three-fund ETF portfolio. One of your ETFs – the one tracking the US market – starts performing really well. Compared to the other ETFs, it pays higher dividends because it’s making more money. And larger dividends could buy more shares of the same ETF.

Over time, without you adding any new money, the value of your investment in the US ETF grows larger compared to the other two. This sounds like good news initially. However, what it really means is that most of your portfolio’s value ends up in the same basket. So, if the US market drops, your portfolio could take a harder hit because a larger part of it depends on that US ETF.

Of course, market downturns are a natural part of investing. But what’s also part of investing is mitigating the risks that come with it.

4. It can take time to buy a share

Let’s say you’re holding the Vanguard Australian Shares Index (ASX:VAS) ETF . At a dividend rate of $0.84 per share (as of April 2024, as per Vanguard ), you'd need quite a big investment for your dividends to buy a whole share. If VAS is at $96 per share, you’d need to hold at least $11,000 worth of VAS (or 114 shares, to be exact) to be able to purchase one new share from the dividends. And while compounding interest is the “eighth wonder of the world”, it needs your money to be actively working – not sitting in your balance.

5. More admin work to do

Every time your dividends are reinvested, it counts as a new transaction. Over time, you end up with many small transactions at different prices and on different dates.

When you sell, you need to keep track of all these purchases to calculate your capital gain or loss for tax purposes. So, this requires a lot of detailed record-keeping and calculations to comply with ATO. In other words, there’s more details to manage compared to simply holding or selling shares that haven't been part of a DRP.

Other considerations

If you decide to exit the DRP, there might be leftover dividends that were too small to buy a whole share. This is called a “residual balance”.

Some DRPs have a specific policy: if you leave the plan, the residual balance could be donated to charity. This happens because the system is set to automatically reinvest dividends. And, if you leave, there needs to be a resolution for any small amounts that can't be invested on their own. This doesn't happen with all DRPs, but some do operate this way (with blessing from the Australian Securities Exchange, of course).

It’s never a bad thing to help a good cause. However, if you’re someone who wants to be in control, it’s good to be aware of the fine print. So, before joining a DRP, we recommend reading through the terms of the residual balance policy. Understand exactly how your dividends will be handled if you exit the plan.

Franking credits

While we’re at it, it’s also worth looking into franking credits and how they relate to your dividends.

Franking credits are a tax perk for investors in Australian-resident companies. When companies make profits, they pay a portion as tax to the government. If these companies then pay you dividends, they include a credit for the tax they already paid. This means when you get dividends, part of the tax on them is already handled by the company.

Now, this is where your marginal tax rate becomes a big factor in your dividend strategy…

A fully franked dividend comes with a 30% tax credit. If your own tax rate is the same as the company's, these credits mean you don't owe any more tax. Those dividends are essentially tax-free.

If your tax rate is lower, you might even get a refund of excess franking credits from the government . However, if you're in a higher tax bracket, you'll still have to pay some tax. But, it’s less than you would without the franking credits.

Who benefits from this setup? Generally, it's retirees and folks in lower tax brackets. Since their tax rates are usually lower, the credits might cover their entire tax liability on the dividends. And they might even get a refund if the credits exceed what they owe. So, for many retirees, franking credits can stretch their income further.

But, here’s a heads-up: there's been chatter in the past about possibly changing or removing franking credits. While nothing is set in stone, it's best to stay updated. Changes to these credits could impact how beneficial they are to your financial strategy.

Lastly, as if we haven’t said this enough: definitely chat with a tax adviser. They can look at your specific financial situation and help you understand exactly how franking credits can work in your favor.

We’d love to hear your thoughts

As we wrap up our chat on dividends, we’d love to keep the conversation going. What’s your approach with dividends? Do you reinvest them for long-term growth? Or do you perhaps use them already as a steady stream of income?

Feel free to drop your thoughts and experiences on our Instagram at @getrichslowclub or @tashinvest and @anakresina . You can also dive into our discussions in our Facebook group which you can find here .

If this episode cleared up some questions, consider giving us a five-star rating or sharing the insights with a friend. Every bit of support helps us bring more value to you and our community.

Happy investing!

Tash & Ana