One of the best parts ofinvesting is when we receive a juicy dividend or distribution. When you receive a dividend it means money is heading your way. They're a great source of income for investors whether they're earmarked for a holiday or paying of bills reinvesting the cash back into your portfolio to wealth.Most investors will be familiar with the term 'dividend', but less familiar with what a 'distribution' is.
Essentially investors receive dividends when they're invested in individual shares. They receive distributions when they're invested in ETFs.
However, when it comes towhat makes up a dividend or distribution, sometimes the details can be a little unclear. So, let’s take a look, firstly at dividends.
How do dividends work?
When a company makes a profit, and has paid tax on that profit, the board must then decide what to do with the after-tax profits.
Some options may include paying down debt, building cash reserves, expanding the business, or even funding a share buyback.
However, one of the most popular uses of the after-tax profits is to return a portion of it to shareholders by way of a dividend payment, while using the rest of the profits to grow the business.
For many blue-chip companies, the size of the dividend payout ratio can often be around 50%, though some companies such as Commonwealth Bank, pay up to 70%-80% of their after-tax profits in dividends.
Many dividends in Australia, also come with a bonus, and that is the issuance of franking credits.
How do franking credits work?
Any Australian company that pays tax on profits in Australia at the full rate of 30%, will provide shareholders with dividends that are franked. This franking comes by way of franking credits, which are also known as imputation credits.
Depending on how much of the company’s profits have been taxed in Australia, will determine if the dividends are fully franked, partially franked or unfranked.
The theory behind franking, is that profits shouldn’t be taxed twice. When a shareholder receives a fully franked dividend, they will receive the dividend, plus franking credits that represent the tax that the company has already paid on that profit.
At tax time, the shareholder will be taxed (at their marginal tax rate) on the combination of the dividend and franking credits. However, they will also receive the franking credits back as a rebate.
The effect of this is that franking will help to reduce the investor’s tax burden. And if an investor has a marginal tax rate below the corporate tax rate of 30%, they may even receive a refund on these dividends at tax time. This is why fully franked dividends are so valuable.
How do distributions work?
Distributions are a share of the income that an investor receives from an ETF.When you invest in an ETF some, or all, of the companies or assets in that ETF will payvarious types of income such as dividends and interest.
Let's look at that in some more detail:
The reason why an ETF provides distributions instead of dividends, is due to its structure, as it’s essentially a fund comprising a portfolio of financial assets such as stocks, REITs, bonds, and cash.
Across this portfolio of financial assets, there are often a variety of ways that income is distributed back to the ETF. For example, some stocks may pay fully franked, partially franked or unfranked dividends. Other stocks may pay distributions, or provide capital returns. Whilst other financial assets in the ETF such as cash or bonds may pay interest.
On top of this, the ETF itself may need to be rebalanced, which will involve the buying and selling of shares, which could result in some capital gains or losses.
The ETF collates all of this income with accompanying credits, and any capital gains or losses, and distributes it all back to the investor. The investor will then use this information at tax time.
An ETF’s distribution will provide the following:
Dividends: These are received from the stocks within the ETF.
Franking credits: This is a collation of all the franking credits from any Australian shares.
Interest: This is received from financial assets in the ETF such as cash or bonds.
Capital gains: These are received from any stocks that are sold in the ETF, such as when rebalancing occurs.
Foreign income: This is income that has been generated from another country outside of Australia. If tax has already been paid on this income in that other country, then the investor may also receive a tax credit.
Investsmart’s PMAs (Professionally Managed Accounts) also pay out distributions, which are a collation of all the distributions received from the various ETFs, the interest from any cash in the PMA, and any capital gains or losses in the PMA due to rebalancing.
InvestSMART makes it easy by providing to investors a summary tax statement at the end of each financial year.
