Stripping for fun and profit

PORTFOLIO POINT: SMSFs in pension mode offer the chance to make the most of high-yielding blue-chips.

One of the big problems facing investors who trade in and out of stocks is the tax bills they face at the end of each financial year. Superannuation funds in pension phase don’t have this problem, opening up a world of wealth creation strategies for those prepared to take on risk.

To recap, a superannuation fund in pension phase is not taxed on any income that is earned within the fund, plus no tax is payable on any capital gains that are realised, and the benefits don’t stop there: if the recipient of the pension is over 60 they also receive their pension tax-free.

A small number of investors are under the misapprehension that because their SMSF doesn’t pay any tax that they forfeit the right to franking credits. Not true. Since 2000 franking credits have become fully refundable if they have not been used to offset any other tax liability. All franking credits are refunded by the tax office on lodging the fund’s annual tax return.

You would be surprised at just how widely this relatively simple area is misunderstood. With the benefits of franking credits providing a significant income boost to super funds in pension mode, today we’ll look at a concept called dividend stripping as a strategy to boost your returns.

Dividend stripping

This strategy has been used by institutions for many years as a means to take advantage of the high liquidity in high-yielding blue-chip stocks. Dividend stripping is the action of buying shares in a company prior to it going ex-dividend for the purpose of receiving the dividend and then selling it once the entitlement for the dividend has passed.

The concept works on the basis that the dividend and the associated franking credits exceed the capital cost of holding the investment over the period. Take Commonwealth Bank, which went ex dividend in February.

You could have bought CBA for $53, held it over the ex-dividend date and then sold 45 days later for $57 (more on this later), taking with you the $1.20 dividend, 48¢ franking credit as well as any capital growth (or loss as the case may be).

This is not a new concept and many stocks rise in anticipation of the dividend up to a month before they are due to go ex-dividend, especially the banks. It’s a strategy that requires careful planning and is best not embarked on a whim.

The advantage of doing this with through your SMSF in pension stage is that it can utilise franking credits effectively. Typically when a company goes ex-dividend, the price of the company falls by the naked dividend amount: for example, CBA would fall by $1.20. The market doesn’t normally reflect the value of the franking credits attached to that dividend and therefore you would be immediately better off by 48¢.

Hang on – it is not that easy!

Most superannuation funds will earn more than $5000 in imputation credits per year. If this is the case then the SMSF must comply with the tax office’s 45-day rule, which requires the SMSF to hold the investment at risk for at least that long (excluding the buy and sell days) to claim the franking credits associated with the dividend.

Secrets to make your dividend stripping work

Only target the top 100 companies with high yields. Typically companies that are internationally traded hold up better as international investors don’t get franking credits anyway so they are less likely to sell the stock off.

Watch out for high dividends and low turnover because after the dividend is paid liquidity will be low and selling pressure high.

It’s quite hard to get this strategy to work through a full-service stockbroker, as the dealing costs mount up. If you are paying 1% to buy the stock and 1% to sell it, then it already has cost you 2%. Given the average dividend is only about 5%, not much is left over. So to reduce your costs negotiate your broker down or use a discount broker.

It is important to be well informed if you are going to use this strategy. For example, knowing when the company goes ex dividend is very important because in Australia many companies, such as the big banks, go ex-dividend just after their profit announcements but others take up to six weeks. You don’t want to be holding the stock longer then you need to be.

Dividend stripping is a fair-weather game. In a rising market it works fantastically well, but in bear markets you can get hurt quickly. There’s not much point getting a dividend of 3% if the stock falls 20%. So as a rule you should only do it with stocks you are happy to hold in your core portfolio.

For SMSFs imputation credits are the equivalent of cash because you can claim them back from the tax office. So super funds should work the dividend season hard, especially those funds that are already supporting their members in pension mode and are focused on income.

With the bank reporting season just about to start the time is right to consider this strategy over the next few months.

We have provided an example of using a $100,000 investment to dividend strip three companies throughout the year, although there are plenty of other examples you can use. In this example, we assume no movement in capital for simplicity, which probably is not realistic and something else you need to consider.

As you can see from the example, if you assume no real movement in capital the return on the investment of $100,000 is $19,491 per annum or about 19%, made up of a whopping $5847 in franking credits!

Dividend stripping is a practical strategy allowing you to take advantage of the tax-free SMSF environment. One this it is not is foolproof: investors need to be disciplined, patient and informed.

If you are able to be all of these things at once (and not all of us can) then dividend stripping should provide you with a significant tax-free increase in the yield of your fund.

Jamie Nemtsas is a partner of Lachlan Partners, owner and distributor of The Investing Times newsletter.