How a DSSP/BSP can have huge tax savings for top income bracket earners

In my investing strategy I state that for my ASX exposure, I am opting for LICs instead of a regular index ETF (e.g. $VAS or $A200). The main reason why is for the great tax benefits to high income earners when reinvesting dividends. There are two specific LICs that allow this (due to a special ATO ruling):

  1. Australian Foundation Investment Company ($AFI)
  2. Whitefield ($WHF)

These two LICs offer a Dividend Substitution Share Plan (DSSP) and Bonus Share Plan (BSP), respectively.
(DSSP and BSP are the exact same thing, just different names).

DRP vs. DSSP/BSP

A more commonly known dividend reinvestment scheme is a Dividend Reinvestment Plan (DRP). Through this plan, dividends are automatically reinvested into the LIC on behalf of the holder. However the only benefit this provides is convenience and saving on brokerage. From the ATO’s perspective, you are still receiving the cash dividend (which is taxed at your marginal tax rate), and then reinvesting the leftover cash back into the LIC.

Where a DSSP/BSP differs is that both companies have a special tax ruling from the ATO that allows them to automatically reinvest dividends on your behalf, without triggering a taxable event at that point in time. The entire dividend is reinvested before tax. However in choosing this option you forego any franking credits. Therefore it only makes sense to use these plans if your marginal tax rate is above 30%. For those on the highest tax bracket of 47% (45% + 2% medicare levy), this represents a 17% tax saving when reinvesting dividends.

Examples

Let’s first look at a simple example.

Imagine you have a LIC portfolio of $100k. You receive a 4% dividend of $4,000.

1. Not using the DSSP/BSP

  • You receive a 30% franking credit, so your $4000 dividend becomes $5714
  • Your $5714 dividend is taxed at 47%, so you receive $3028
  • You reinvest this into the LIC, bringing your portfolio size to $103,028

2. Using the DSSP/BSP

  • You forgo the 30% franking credit, so you receive the initial $4000 dividend only
  • Your $4000 is not taxed at this point in time
  • You reinvest this into the LIC, bringing your portfolio size to $104,000

You can start to see how using these plans will have a compounding effect over the years in growing your LIC portfolio.

Now let’s look at a more realistic example which includes capital growth.

Assumptions

  • Starting capital of $100k
  • Adding $50k per year
  • Reinvesting all dividends
  • Average returns of 7% per year, comprised of:
    • 4% dividends (5.7% fully franked) and;
    • 3% capital growth

Portfolio size
The difference in portfolio size after 15 years is over $100k!

Dividends
Keeping in line with the assumption of 4% (5.7% fully franked) dividends annually, this results in the following figures:

Using the DSSP/BSP = $78,967
Not using the DSSP/BSP = $72,949

That’s over an additional $6k in dividends received per year.

The “catch”

So you’re saying I can get a guaranteed 17% tax saving for nothing?

Now, does this all sound too good to be true? Well here is the “catch”.

You aren’t actually avoiding tax – you’re simply delaying the tax for a later time. How this works is each LIC share you gain through these plans is considered as being bought at $0. Therefore the average cost price of each share in your portfolio is made lower over time, which means that when you finally do sell your shares, you will be liable for a larger CGT event.

However if you never intend to sell your shares and just want to live off the dividends (e.g. a goal for many on the path to FIRE), then you will never need to pay this tax.

Concluding thoughts
As I am now beginning my LIC portfolio and in the top tax bracket (just barely), it makes sense for me to focus on those that offer a DSSP/BSP to turbocharge the growth of my portfolio. AFIC and Whitefield are also two of Australia’s oldest LICs with quite low management fees.

For a great background on both these LICs, I highly recommend reading the following two reviews at Strong Money Australia:

  1. Australian Foundation Investment Company (AFIC) Review
  2. Whitefield Limited (WHF) Review


References
These are the two articles which I’ve found the most helpful on the topic of DSSP/BSP:

Here are the details of both plans direct from the source:



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