Looking for ways to earn extra income from your investments?

Shares, Listed Managed Investments (LMIs) and Instalments
Shares come in a variety of shapes and sizes, many of which pay dividends. Dividends provide income in much the same way an interest rate security pays interest. One obvious difference however is that unlike interest, a company can vary the amount they pay or forgo paying a dividend if business conditions deteriorate. With careful selection of dividend paying stocks, this risk can be greatly reduced.

As an example, a stock like Telstra paid 25c in dividends last financial year - 12c in September and 13c in March. Having traded between $4.45 and $5.16 this represents a yield anywhere from 4.84% to 5.6%. Today at $5.00 per share assuming Telstra pays a similar dividend for the next 12 months, buying Telstra yields 5%. And if your marginal rate of tax is the same marginal tax rate as the corporate tax rate, fully franked dividends* are tax-free. For those on a marginal tax rate higher than 30 per cent, imputation credits** reduce the liability on the dividend, and if your marginal rate of tax is less than 30 per cent you may even receive any imputation credits that can’t be offset against tax payable in a tax year, refundable in cash.

Listed managed investments are an alternative for investors that want exposure to a portfolio of assets, such as shares or property, but don’t have the time or perhaps the interest in buying and monitoring a portfolio ofindividual shares. LMIs are like managed funds, except they are listed on ASX so you can buy and sell LMIs just like shares and that includes in a Self Managed Super Fund. Listed investment companies and property trusts have traditionally provided investors with a steady source of income with yields ranging between 2-5% and 6-10% respectively.

Listed Managed Investments encompass six broad categories:

• Listed Investment Companies (LICs)
• Property Trusts
•  Infrastructure Funds
•  Pooled Development Funds (PDFs)
•  Exchange Traded Funds (ETFs)
•  Absolute Return Funds

Instalments are yet another way of accessing dividends and franking credits. They have become a popular way for investors to gain exposure to the sharemarket. Instalments are financial products, that allow investors to gain direct exposure to shares, listed property trusts (LPTs) and exchange traded funds (ETFs) by making a part payment upfront and delaying an optional final payment (or second instalment) until a later date (expiry date). This allows you to buy shares or other financial products, for a fraction of the current market price of those shares or financial products, whilst receiving the benefits of capital growth, dividends and franking credits. 

Generally instalments are used to leverage or diversify an investment portfolio, however they can also be ideal for trading short-term price movements.  Unlike other forms of gearing, you are not obligated to repay the final payment, making them eligible for Self Managed Super Funds.

Instalments effectively allow you to gear your exposure into the dividend, which can increase your gross yield substantially provided you are comfortable with the idea of borrowing.  Using the above example, assuming Telstra is at $5.00 you could buy an instalment for $2.50.  Given Telstra pays 25c in dividends, the yield for the instalment would be 10% compared to the yield for the shares at 5%.  In addition the franking credits would be passed through to you as well.  For more information on instalments visit the ASX Website.

Interest rate securities…
Interest bearing securities are another alternative and should not to be confused with bank accounts and term deposits which pay in the vicinity of 0 – 5.5%. On the subject of bank accounts and term deposits if you have one that pays virtually nothing consider swapping to one that doesn’t!  Tax on interest is punitive so although 5.5% might seem appealing the after tax return is a lot less. A more rewarding alternative for an increasing number of investors reliant on interest income is interest rate securities traded on ASX.

Similar to bank accounts, interest rate securities pay a fixed or floating rate of return however unlike bank deposits their price fluctuates and are not guaranteed. The interest often takes the form of franked dividends or in some cases tax deferred distributions. This means a better result for investors as the dividend is grossed up to account of the tax already paid by the company on earning a profit, prior to paying a dividend. The table illustrates the big difference in the after tax returns for an investor paying the top marginal tax rate on a notional $7.00 depending on how it is received. 

The companies that issue these securities and borrow your money promise to pay you a specified rate of interest over the life of the security and repay the principal at maturity. As many of the companies are investment grade rated and of high quality there is low risk in the company not being able to honour its obligations. Rates on many of these securities pay 3-4% more than a typical term deposit so you do need to remember the old adage; the higher the return, the higher the risks.

Options for the investor with a portfolio 
For someone with a share portfolio writing calls against shares during flat periods can greatly improve returns. Known as covered call writing the shareholder undertakes to sell their shares at a price, at some point in the future. In return they receive a premium and if the share(s) don’t reach that price the premium is retained. Studies suggest writing options adds value over time and brings a lower level of volatility (variance in the value of a portfolio). So rather than increasing risk, writing options against a portfolio reduces it because the premiums received lower the cost price of the shares. As most options trading is short dated option premium is treated as income and is taxable.

Where to from here?
If you would like to earn more income than a bank account or term deposit without paying tax on up to half of every dollar, remember there are a variety of different products that can help you achieve your goal. Why not email this column to your adviser and make an appointment to start earning more.

* A franked dividend is a dividend paid by a company out of profits on which the company has already paid tax. The investor is entitled to an imputation credit, or reduction in the amount of income tax that must be paid, up to the amount of tax already paid by the company.

** Imputation credits are the tax credits passed on to a shareholder who receives a franked dividend. Under provisions of the Income Tax Assessment Act, imputation credits entitle investors to a rebate for tax already paid by an Australian company.

© All rights reserved 2004. This material is educational and it is not intended to constitute financial advice.

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