With the cash rate at a low, Australian investors have turned their attention towards high-yielding dividend shares as their preferred form of income – and why not?
After all, many ASX dividend-paying shares have delivered far greater returns than what would have been realised from investing in a term deposit or government bonds.
Dividend-paying shares provide a reliable income and also have the potential to deliver substantial capital gains when held for a long periods of time. These advantages far exceed those that many other securities offer.
So just what are dividends, exactly?
Dividends represent a distribution of a company's profits to its shareholders and are often paid on a semi-annual basis.
Say you buy shares in a company at $1.00 each – and a dividend of 6 cents per share is paid each year – then you would recognise a 6% return.
Whilst many Australian investors consider dividend-paying shares as an attractive investment in that they provide a steady flow of income to live off of, others will take advantage of the ability to reinvest the proceeds to further grow their wealth.
'Franking' and dividend tax benefits in Australia
That's another dimension to dividends that make them even more attractive than returns from term deposits: tax benefits!
In Australia, companies can attach what are known as 'franking credits' to their dividends, which reflect the amount of tax already paid by the business.
It's true: Unlike in many other countries around the world, dividends are not 'double taxed' in Australia. (We really are the Lucky Country.)
Companies that frank their dividends pay the corporate tax rate (some 30%) on their profit and distribute the remainder to shareholders.
The shareholder receives the credit for the tax already paid by the company and is then only required to pay any 'extra' tax to match their individual tax obligations.
This means that a 5% fully franked dividend actually carries a greater after-tax cash flow than a 5% return on a term deposit in that it also carries the franking credits which are used to offset a portion of the investor's taxable income!
Whilst there may be a number of benefits to investing in dividend-paying shares, there are also, it bears noting, a number of factors that investors will want to be wary of.
First and foremost, while a term deposit might have a guaranteed return, dividends in ordinary shares do not. For example, a company might boast a yield of 6%, but if it has a poor year of earnings it may not be able to distribute quite as much.
Such a happening could also have a negative impact on the share price.
Typically, investors trend towards the more 'defensive' ASX stocks such as the big four banks, including Australia and New Zealand Banking Group (ASX: ANZ), Commonwealth Bank of Australia (ASX: CBA), National Australia Bank (ASX: NAB) and Westpac Banking Corp (ASX: WBC), as well as Woolworths Limited (ASX: WOW), Wesfarmers Ltd (ASX: WES) or telecommunications giant Telstra Corporation Ltd (ASX: TLS) as their source for high yields and income.
This is because these shares are considered to be 'safer' investments and their dividends are often seen to be the most reliable and sustainable.
In the end, although investing in dividend-paying stocks may not be quite as safe as investing in term deposits or government bonds (which are effectively risk free), the benefits that can also be realised from investing in the right company could be tremendous.
