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Why high yield dividend shares can be detrimental to your wealth

I think that high-yield dividend shares can be detrimental to building your wealth, particularly if you choose the wrong ones.

Reason 1: Tax

Taxes are the subscription fee for being part of a good society, but you don’t need to be handing over extra when you don’t need to.

Unless you’re in a low tax bracket (such as within superannuation or a low income earner), any dividends you receive may be taxed at around a third or even more.

If you get a sustainable 10% return from a high-yield dividend share then you could be handing over a third of it to the tax man each year. Compare that to a 10% capital growth from something like Xero Limited (ASX: XRO) or A2 Milk Company Ltd (ASX: A2M) – you don’t pay any tax unless you actually sell the share. I think it makes a big difference over time.

Obviously there’s the benefit of dividend franking credits which reduces your taxes owed, but you still have to make up the extra tax unless you’re in that lower tax bracket position where the franking credit rate is higher than your tax rate.

Sometimes paying the tax can be worth it if you just want a high net yield from your investments and you can find a reliable dividend payer.

Reason 2: It may be a bad investment

Having a high-yield dividend share shouldn’t mean you overlook all the other areas of a business. Does it have a good balance sheet? Is there good prospects for the business and its industry as a whole?

A high yield may mean little growth, which suggests the business could be mature or challenged.

If it’s a bad investment then you could easily suffer wealth destruction from falling earnings and a falling share price. And the dividend could be cut. There’s not much point going for the big dividend if the dividend is then cut a year or two later.

Just look what has happened to Telstra Corporation Ltd (ASX: TLS) and National Australia Bank Ltd (ASX: NAB). Lower share prices and lower dividends compared to a few years ago. Over time it’s the ‘growth’ businesses that will keep paying larger dividends so you can receive a good yield on cost. Plenty of high yield dividend shares are actually yield traps, particularly in these coronavirus times. 

What high yield dividend shares are worth buying?

It depends how high of a yield you want to go and if you don’t mind paying the elevated levels of tax.

Rural Funds Group (ASX: RFF) has a FY21 distribution yield of 5.9%.

Brickworks Limited (ASX: BKW) has a grossed-up dividend yield of 6.3%.

WAM Microcap Limited (ASX: WMI) has a grossed-up dividend yield of 7.4%.

Future Generation Investment Company Ltd (ASX: FGX) has a grossed-up dividend yield of 7.9%.

WAM Research Limited (ASX: WAX) has a grossed-up dividend yield of 10.9%.

Naos Emerging Opportunities Company Ltd (ASX: NCC) has a grossed-up dividend yield of 13.25%.

At the current prices I’d probably be happy to go for WAM Microcap, Brickworks and Future Generation as my preferred three high yield dividend share picks because the yields aren’t too high. But all of them could be good long-term picks for dividends.

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Motley Fool contributor Tristan Harrison owns shares of FUTURE GEN FPO, RURALFUNDS STAPLED, and WAM MICRO FPO. The Motley Fool Australia owns shares of and has recommended Brickworks, RURALFUNDS STAPLED, and Telstra Limited. The Motley Fool Australia owns shares of A2 Milk and Xero. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.