They say that death and taxes are the two great certainties in life. But whoever said that was clearly not aware of the wonderful dividend imputation system we enjoy here in the lucky country.
Ok, so tax law is not the most interesting of topics, but if you don't like paying tax, it's worth getting to know the basics. It could save you thousands.
It's not that complicated really.
Aussies are all about a 'fair go' and the local tax man, it seems, is no different. He reckons it's not right to tax the same lot of income more than once. And because companies pay dividends out of after-tax income, you really only need to account for the difference between your personal rate of tax, and the company's tax rate. (It only applies to tax the company has paid to the Australian Government; the same doesn't apply for foreign income.)
With Australian companies taxed at 30%, that means that even investors who are on the highest rate of personal tax get to make a huge saving. Those that pay less than 30% — including those with investments in superannuation — actually get to claim back some tax!
That is, you not only pay no tax on your dividend, you actually get a bit extra from the tax man! It's a huge benefit, and one worth considering for anyone weighing up the various investment options.
Of course, other investments have tax benefits too — for example, you can claim many of the expenses relating to investment properties. So making comparisons can be tricky. Fortunately, help is at hand!
Every year, the ASX and Russell Investments release a joint report on long term investing. Among other things, it tracks the performance of all the various asset classes over the past ten years.
In the most recent report, it should come as no surprise that shares again delivered the best long term returns; that's almost always the case. However, in the most recent ten year period, through to the end of 2014, residential property came in a very close second; delivering a 7% average annual gross return compared to 7.1% for shares.
It was also unsurprising to see the woeful long term returns delivered by cash; which barely managed to outpace inflation over the past decade. And with interest rates now far lower than they were for most of that period — and seemingly headed lower — things aren't likely to improve any time soon!
What's interesting, is how those returns stack up after tax. In the report, returns from the various asset classes were adjusted for the highest and lowest marginal tax rates, and also for the tax paid by superannuation funds.
Source: ASX-Russell Long Term Investing Report 2015. Fixed interest and foreign investments excluded.
Poor old cash turns out to do even worse on an after-tax basis — it doesn't receive any concessions whatsoever.
Because of the deductibility of many expenses, residential investment properties still hold up fairly well on an after tax basis. Even those paying the highest rate of tax managed a 4.9% net yearly return.
But thanks to the dividend imputation system, shares managed to further extend their lead on the other investments classes on an after tax basis. In fact, the after-tax return was actually higher than the gross return for those in super and those on the lowest rate of tax.
Because little differences in average returns really add up in the long term, investors would do well to take note of this.
On average, the investor who bought $500,000 worth of shares for their super fund ten years ago is almost 14% better off than the person who bought a $500,000 investment property for their super fund.
That's a difference in after tax return of more than $127,000 in just ten years. Certainly not what you would expect given that shares and residential property yielded gross returns of 7.1% and 7% respectively.
Foolish Takeaway
At Motley Fool Dividend Investor, the service I run, we love dividends for a whole host of reasons — but certainly the tax advantages are one of the more attractive features. The companies we have recommended to our members already have a compelling average yield of 4.2%, but that grosses up closer to over 5.5% when you account for the tax benefit.
With term deposits pitifully low, and rental yields dropping, shares have never been more attractive for those seeking a reliable and tax effective income.
