If you own shares you probably enjoy receiving regular dividend income. However, if you don’t rely on those dividends for cash to live on, one way to get more value from the money is through a dividend reinvestment plan.
Dividends represent the slice of a company’s annual profit that’s paid out to shareholders, and in the case of some of our best known listed companies, dividend yields can be impressive. This year for instance, Commonwealth Bank shares delivered a share of 4.85%; Telstra 7.28%; and Wesfarmers 4.57%. That’s considerably higher than the return you could earn on cash savings.
Strong yields are only part of the picture. Dividends are also lightly taxed. Shareholders are credited for company tax paid on the profits that dividends are paid out of. Even low income earners can benefit with the potential to receive a tax refund for unused franking credits.
If dividends don’t play an essential role in your household income, it’s possible to reinvest the money through a dividend reinvestment plan (DRP). Instead of receiving a cash payment, the dividend is exchanged for additional shares, typically at the market value applying on the date the dividend is paid.
A number of Australia’s largest companies offer DRPs including Telstra, National Australia Bank, IAG, Suncorp, AMP, Origin Energy and Rio Tinto, and there can be advantages to using dividends this way. First, it’s a simple way to avoid brokerage fees, and shareholders may also be entitled to a discount on shares purchased using a DRP. Woolworths for instance offers a 1.5% discount through its DRP.
On the downside, even if dividends are reinvested into shares, the money is normally required to be treated as a cash payment and declared in your annual tax return. Shares acquired through a DRP are also subject to the same capital gains tax rules as shares purchased in the normal way. So a DRP is not a way of trimming your tax bill. Note too, each DRP share purchase will have a different acquisition price and date for CGT if and when you sell, so do keep good records of each reinvestment.
A DRP can be a set and forget way to invest without concerns over market timing. But it can also mean building a substantial holding in one particular company over time. This being the case, only sign up for a DRP if you believe the company has strong prospects for the future.
It also pays to regularly review your involvement in a DRP. A key risk is that you could end up having a large concentration of shares in a company whose value is falling without the benefit of having received past dividends as cash in the bank.
Talk to your adviser about whether dividend reinvesting could play a role in your financial plan.