DRP vs DSSP?

If you’ve come this far, you should already know what a Dividend Reinvestment Plan (DRP) is, or at least be somewhat familiar with the concept. However, there’s a lot of confusion surrounding DRP’s cousin, the enigmatic DSSP (Dividend Substitution Share Plan). This post will explain the key differences between DRP and DSSP, and should hopefully make it easier to work out which of them (if either) is suitable for you. Fair warning: we’re going into the weeds with this one, as the key factors are about optimising your taxes.

A key part of gradually building wealth is reinvesting the proceeds of your investments. Shares pay delicious dividends on a regular basis, but if you take that money and splurge it, then your portfolio won’t grow as fast as it could. Instead, you should pour that cash back into your portfolio. There are a number of ways to do that. The most obvious method is just to take the dividend payment that arrives in your bank account and buy more shares with it. This gives you complete control over how you reinvest it, letting you pick and choose which of your investments you want to put additional capital into. Of course, just like with any other transaction through your brokerage account, you have to pay a brokerage fee when you do this.

Dividend Reinvestment Plan (DRP)

Most Australian shares also give you the option of reinvesting the dividends automatically. To do this, you just login to the company’s share registry website and select the Dividend Reinvestment Plan. If you’ve just bought shares and don’t know about the registry yet, don’t panic. You’ll receive a letter in the mail about a week after your purchase, which will give you the details for the registry and tell you how to login. It’s a piece of cake. Once you’ve chosen the DRP, you can just sit back and relax, and watch your number of shares grow year after year without any effort from you. Each time a dividend payment happens, instead of the money appearing in your bank account, additional shares will magically appear in your portfolio. I find that immensely satisfying!

Some people don’t like using the DRP because it creates a long list of small transactions in your share purchase history. It’s important to keep accurate records of how much you paid for all your shares, because when (or if!) you decide to sell them, you need to calculate exactly how much the price has increased, in order to calculate how much capital gains tax you owe. Purchasing a big chunk of shares is easy to keep track of, but then the DRP might add a few additional shares several times a year, each with a different purchase price that needs to be included separately in your bookkeeping. Personally, I don’t care about that, as Excel records large and small numbers with equal ease. It’s 2018, you don’t need an abacus for this stuff!

A common misconception about using a DRP is that it saves you taxes. It doesn’t. When you earn a dividend, that money is yours, and you have to include it in your income when you file you tax return. It doesn’t matter whether the money actually hits your bank account or not. Using the DRP to automatically reinvest your dividend is just a shortcut for taking the cash you’ve earned and buying more shares with it. It saves you money by cutting out the middleman, so that you don’t need to pay brokerage, but the taxman isn’t so easily deterred.

Income tax

Paying taxes on dividends is a strange sticking point among the investor community. Personally I’m very happy to increase my income, even if it means paying more taxes, because obviously it also increases my after-tax income. But part of that is because I’m luckily/unluckily on a relatively low marginal tax rate. But part of it is also based on my chosen investment strategy. I’m working towards building up my passive income stream in order to retire and live off the dividends without having to sell down any of my capital. For someone with a more Boglehead approach, of building up capital towards retirement and then selling chunks of shares to fund retirement, they might be more focused on minimising their taxes during the accumulation phase.

Bogleheads (but ironically not Bogle himself) often complain about dividends, because income tax is paid at your marginal tax rate, whereas capital gains tax is paid at a 50% discount, as long as you’ve held the asset for more than a year before you sell. Whereas Thornhill investors think that complaining about free money is lunacy! Of course, dividends aren’t really free money, as Bogleheads will eagerly tell you, because the dividend comes out of the company’s balance sheet, reducing their capital value. So for most investors, the question is simple: do you buy high-growth shares that pay little or no dividends, to minimise your income taxes? Or do you buy growing-dividend shares to maximise your income stream for life? I believe the answer to that is a personal and emotional one, rather than a pragmatic one.

However, there is a third path, which avoids the income taxes of dividend stocks, while still setting you up with a solid passive income stream for retirement. But it’s not widely available, and it’s even less widely understood. And that’s the Dividend Substitution Share Plan, or the Bonus Share Plan as it’s sometimes known.

Dividend Substitution Share Plan (DSSP)

Sometimes curious new investors ask in forums or on Reddit whether there are ETFs that reinvest all their dividends without paying them out to shareholders at all, thus increasing the capital growth without incurring any income taxes. And of course, the answer is no, because ETFs are trust structures which are forced to distribute all the income they earn. But really it’s the question that’s wrong, not the answer. A lot of finance neophytes assume that ETFs are the only way to invest, but that’s just because they get a disproportionate amount of chatter on the interwebs. There are diversified investments options available which do exactly what they’re looking for, but obviously not through an ETF structure. Instead, they should be looking to LICs. In fact, two LICs in particular, because there are only two which offer this function. They are Australian Foundation Investment Company, the largest LIC on the Australian market, and Whitefield. (ASX:AFI and ASX:WHF) They offer the Dividend Substitution Share Plans (DSSP) as an alternative to the DRP. Whitefield calls it the Bonus Share Plan (BSP) instead of DSSP, but it’s exactly the same.

Essentially the DSSP / BSP are just another way to automatically reinvest your dividends. Every time a dividend payment would happen, you get shares instead of cash. That sounds the same as the DRP, right? However, the big difference is in the way they are taxed.

When you use the DSSP, you receive shares instead of the dividend. I’m emphasising “instead of” because that’s really the crux of it. You officially do not receive a dividend, so there’s no income to declare. That means you can grow your number of shares every dividend season, without having to pay any extra income taxes.

It’s not all roses though. The new shares you acquire through the DSSP are added to your portfolio without you paying any money for them. You didn’t pay for them with the dividend you would have received, because you didn’t actually receive a dividend payment. That has important implications for future capital gains tax. Of course, by eliminating the dividend payment you also lose the right to any dividend imputation credits that would have been attached to the dividend, but we’ll get back to franking later.

Capital Gains Tax (CGT)

Whenever you sell an investment, you need to pay tax on the amount your investment has grown in value. It’s not as complicated as it sounds. You just take the price you’re selling it for, and subtract the price you bought it for, to figure out how much it’s grown. If you bought different parcels of the same shares at different times, you need to calculate each parcel separately, but luckily Excel makes this easy. Once you’ve figured out how much your investment has grown, divide that amount in half if you held the investment for more than 1 year. Then you add the result to your taxable income for the year and declare it on your tax return.

If you had held the shares for a while and were using the DRP, you’ll have several small parcels of shares which you acquired through the DRP, each with a different purchase price (sometimes referred to as cost base). Those purchase prices will probably be somewhere in between your original purchase price and your final selling price, and they’ll match whatever the going market rate was at the time you reinvested the dividends. That means the capital gain will simply be the difference between the selling price and the buying price, as normal.

On the other hand, if you had been using the DSSP rather than the DRP, you’ll have several small parcels of shares which you acquired without paying for. That means that the difference between the selling price and the buying price is the full value of the selling price. In other words, the capital gain will be enormous! You’ll have a very large CGT bill to pay. However, there’s a slight twist to that. Instead of counting the cost base (purchase price) of the DSSP-acquired shares as $0.00, the cost base is averaged out among the rest of your holdings of that share. For example, if you bought 1000 shares at $5 each, then got 40 shares from the DSSP at $0 each, you now have 1040 shares which you paid a total of $5000 for, so the cost base per share will become $4.81. The end result is the same as if the cost base were $0.00, assuming you sell all of the shares at the same time, so you only need to worry about this cost base spreading if you sell some portion of your holdings.

Therefore, using the Dividend Substitution Share Plan will eliminate your present income tax burden from the dividends, but it will also increase your future capital gains tax liability when you decide to sell the shares. The end result of the DSSP is that your holdings will get an unrealised capital gain baked into them, equal to the size of the dividend. That’s the whole thing in a nutshell. And therein lies the essence of figuring out whether the DSSP is suitable for you.

Your mileage may vary

Everyone will have a different perspective on whether to use the DSSP, because it depends so heavily on your personal circumstances. I’m going to go through some example cases as a demonstration of how it might suit different types of investors, but you’ll need to figure out your own personal financial situation and goals for yourself.

If you plan to hold onto your shares forever, enjoying the dividend stream and never selling, then the DSSP could be a good option for you. In that case you’d use the DSSP during the accumulation phase, and then switch to receiving cash dividends to fund your retirement. That’s the ideal case that the DSSP was designed for. The increased capital gains won’t matter, because you’re never going to incur a capital gains event. However, you need to be certain that you’re not going to sell. If you change your mind later, or if you’re forced to sell by some outside pressure such as losing your job, then the DSSP could turn out to be a very costly mistake. You also need to be aware that other things besides selling can sometimes trigger capital gains events. For example, becoming a non-resident for tax purposes can lead to you having to pay CGT on your investments. I’m not planning to live abroad in the future, but I don’t want to rule it out completely, so this deters me from the DSSP for the time being.

If you’re not earning a very high salary at the moment, then the DSSP probably isn’t for you. This describes my situation, and it’s the main reason why I use the DRP instead of the DSSP. My average marginal tax rate is just over 30%, and the dividends from both AFIC and Whitefield are fully franked, so they’ve already had company tax paid on them at a rate of 30%. I only need to pay tax on the dividends at the difference between the company tax rate and my marginal tax rate. I could save a little bit of money by switching to the DSSP, but it’s not worth the future increase in capital gains, even though I’m not planning to ever sell my holdings. Of course, if your marginal tax rate is below 30%, then the DRP is strictly better for you than the DSSP, because you won’t pay income tax on the fully franked dividends anyway.

If you’re currently earning a motza, and you know you’ll be on a significantly lower tax rate when (or if) you sell the shares, then the DSSP could be a great way to reduce your taxes. If you’re in the highest marginal tax bracket then you’d lose close to 50% of any dividend payments you receive (as cash or as DRP shares), so the DSSP would allow you to keep all of your pseudo-dividend earnings. If you then aim to sell the shares after you’ve retired, at a time when your marginal tax rate will be closer to zero, then the increased capital gains won’t be such a burden, especially if you sell in portions over several years to optimise the tax efficiency.

If you’re buying shares in your child’s name, then the DSSP could potentially be a good option, depending on how you plan to hand over control of the shares to the child. Children pay income tax at the highest marginal rate, because it’s rightly assumed to be actually the parents’ money, so eliminating the dividends could be a good strategy. Most children, once they reach 18 and go to university before joining the workforce, will have several years at a very low tax rate when they can sell the shares without worrying much about the capital gains. This could be a simpler way of establishing investments for your child than using insurance bonds or buying shares within a discretionary trust.

Crunchy grey numbers

Those are the broad categories that illustrate the core of the decision about whether to use the DSSP. However, where it gets really crunchy is figuring out where you sit between those categories. For example, if you plan to hold long term, but maybe sell some of your holdings during retirement, and you’re on a moderately high income now during the accumulation phase, then you need to crunch the numbers in the grey area.

On the surface, it’s a simple calculation based on your present tax rate and your expected future tax rate when you plan to sell. If you’re above 30% tax, the DSSP can save you money in the short term. If you know you’ll never sell the shares, then the DSSP is a no-brainer, and most people who invest in AFI or WHF are probably doing it for the income stream rather than the capital gains. (This gets into Boglehead versus Thornhill territory again though, which I’m trying not to wade into too much here.) If you think you will, or even might, sell the shares, then you need to weigh the probabilities and varying tax rates over the span of your investment. The higher the chance of you selling the shares, then the higher the threshold for your present tax rate before the DSSP becomes worthwhile. For example, if you think you’re very likely to sell the shares, then you might not want to use the DSSP unless your current marginal tax rate is above 45%. I’ve seen calculations where people try to figure out that risk gradient, but I don’t think there’s much value in them, because it depends entirely on your level of confidence in your personal investment plans.

If you could accurately calculate the comparative tax benefits of the DSSP, you wouldn’t even need to break even to make it worthwhile. Deferring the tax burden to later in life is beneficial even if the amount of tax paid ends up being the same. You can use the extra savings now to earn additional compound interest, so there’s always an incentive to leave the tax for later.

If you are considering using AFI’s DSSP or WHF’s BSP, you should research them thoroughly before deciding. You can read all the relevant information direct from the horses’ mouths here and here.

A little from column D

Finally, remember that you can change your preference easily at any time. If your marginal tax rate increases, for example if you get a sweet promotion, you could then switch on the DSSP to minimise your income tax. If you spend some time at a reduced rate, such as taking maternity or paternity leave or taking some time off to study, then you could switch back to the DRP for that time. Or if you find your expenses rising unexpectedly, perhaps because of an additional mouth to feed (unexpected triplets, anyone?), then you could opt out of reinvesting dividends altogether and temporarily take them as cash to help make ends meet. You can even mix and match different options at the same time, applying one plan to a set portion of your holdings and another to the rest. Just make sure you research your investment options, then choose a plan that suits you financially and allows you to sleep well at night. At the end of the day, as long as you’re investing in quality companies and reinvesting as much as possible, you’ll have plenty of dividends to seize in your retirement.

Disclaimer:

Long AFI, but not WHF. However, the underlying holdings aren’t all that different between the two, so make of that what you will. I’m not a certified adviser, so do your own research before deciding on a reinvestment plan.