There are many styles of investing that individuals can choose when pursuing the wealth that the share market can generate. There's growth investing, value investing, momentum trading… the list goes on.
But one of the most popular avenues for pursing share market success is dividend investing. Investing for cash flow. For passive income.
Dividends are cash payments made from companies to their shareholders – usually every six months. You often have the ability to elect to automatically reinvest these payments back into the shares of the company in question – or if not, you have the choice to do so manually. In this way, you can effectively and visibly compound your investments.
There's nothing wrong with this path. It's a path I personally follow to some degree, along with many great investors like Warren Buffett.
But there is a hidden cost – a cost that many new investors who do decide to follow the path of investing for dividend cash flow might not be aware of.
Tax.
How does tax affect dividend returns?
See, dividends make up a proportion of the total shareholder returns (TSR) an investor can expect from their ASX shares.
If you take a typical ASX growth share, a company that doesn't pay a dividend but instead reinvests its profit for future growth – that company's share price might double in a five-year span to reflect this. As a shareholder, your TSR is a 100% gain made up of this capital growth – on paper at least.
But if you were to receive the same TSR from a dividend-paying share (from both capital growth and dividend payments), the dividend proportion of this TSR would be paid to you as taxable income. Every dividend you receive is liable for tax as income. Every year you receive them.
There's no capital gains discount, no carrying losses and no choice on when to realise your gain (unlike a pure growth share).
Of course, if you sell your growth shares for a 100% gain, you typically have to pay tax on that gain. But you can decide if and when to sell – it could be never. That growth share could start paying a dividend (on which you'll pay tax on), but if you never sell the shares, the taxman (or taxwoman) is never cut a share of your profits.
In this way, dividend investing is a path that has a hidden cost – the constant paying of tax on a proportion of your returns.
Foolish takeaway
I'm not trying to dissuade anyone from pursuing dividends as a form of wealth creation. But I am saying that you should understand exactly how this strategy works if you do want to pursue it – its advantages and disadvantages.
