On the surface, receiving passive income sounds like a dream come true. After all, who wouldn't want a source of income that arrives in your bank account whether you work or not, whether you are healthy or sick, or whether you are 18 or 82? It is for this precise reason that many Australians choose to invest in ASX shares.
Australian companies are well known for their dividend-paying prowess. Our tax system arguably encourages companies to pay out a portion of their profits as income to their shareholders. As such, many of the most famous names on the ASX, whether they be Commonwealth Bank of Australia (ASX: CBA), Telstra Group Ltd (AX TLS) or Coles Group Ltd (ASX: COL), tend to pay out fat dividends to their investors every six months.
Dividends are wonderful, no matter one's age. I love receiving them myself. However, I have recently been running some numbers, and I have come to the conclusion that they may not be the best thing to aim for if someone is of a certain age.
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Why passive income isn't the best priority for everyone
So how could passive income possibly be a bad thing? Well, it comes down to one thing: taxes. See, when you receive a dividend, you must declare that income as, well, income. Taxable income, to be precise. If you are a retiree, and you receive dividends from a superannuation or pension fund, you may be able to enjoy that income tax-free. However, if you are not of retirement age, that dividend gets lumped right next to your salary on your tax return.
The most effective way of investing in the share market is to let your investments compound, uninterrupted, over time. When you earn 8% on 8% on 8%, wealth starts to build exponentially.
If you have a stock that earns a return on investment of 8%, and reinvests all of that money back into the business, its share price should rise over time to reflect this. As such, you as the investor enjoy the effects of compounding tax-free and in their entirety. Sure, you'll only see the gains on paper. And they will be volatile over short periods of time. But you just need to look at the stock price of Berkshire Hathaway Inc (NYSE: BRK.A)(NYSE: BRK.B) over time to see this in action.
Cutting the taxman in, or out
By contrast, let's look at a company that retains only half of its earnings for reinvestment, and pays out the other half as passive dividend income. For simplicity's sake, let's say it grows at 4% a year and pays out a 4% dividend yield.
If you take that dividend cash and spend it, then you'll have a subpar investment. If you reinvest those dividends back into more shares, you'll get that 8% return. But without the cut you have to give to the taxman. If those dividends come with full franking credits attached, your losses will be mitigated. Although you will probably still be at a financial disadvantage.
Let's say a young person, 40 or under for argument's sake, follows this second path over a lifetime of investing. Chances are they will end up poorer than if they had prioritised investments that direct more cash into future growth and less into passive income
As such, you can see why pursuing passive income may not be the right path for most younger investors. Sure, it's nice to have some of your gains in your pocket, and not sitting on paper. But it's arguably only once one's wealth has been maximised, and one has entered into a tax-free pension phase, that prioritising passive income from our investments truly makes financial sense.
