Under 40? Here's why buying ASX dividend shares might be a mistake

Every investor loves a good ASX dividend share. What's not to like? Dividends are passive income in the purest sense of the phrase. They arrive in your bank account regardless of how old you are, whether you are sick or healthy, or whether you work a day job or not.

Here in Australia, dividends are particularly popular. That's thanks in part to our unique system of franking, which gives income received from dividend-paying shares preferential tax treatment compared with other kinds of income.

Now, investing in shares is almost always a good thing. ASX shares ae one of the best paths to take if one wishes to build financial independence. And hopefully one day, freedom. However, I think that many Australians on the younger side of life may be making a mistake when it comes to the ASX shares they are buying.

The power of compounding

Younger investors are inherently at an advantage thanks to the time they have on their side. The whole point of investing in assets like ASX shares is to harness the power of compounding to (hopefully) grow our wealth exponentially. The more time we have, the more we can harness that extraordinary power.

The late and legendary investor Charlie Munger once said that one of the most important principles of investing is to ensure that we don't "interrupt compounding unnecessarily". Unfortunately, receiving a dividend does interrupt that compounding. How? Well, when a company declares a dividend and pays it out, the recipient needs to declare that dividend as income and pay tax on it. Sure, if the payout is franked, the tax will be lighter. But it will be taxed, nonetheless.

In order to keep the compounding going, you might think that all we need to do is reinvest those dividends back into more shares. But since our dividends will be taxed before we can reinvest them, an investor will always be putting in less than they receive, unless they replace that lost tax with additional capital.

Put simply, dividends are a leak in the wealth bucket.

Are ASX dividend shares costing you?

Consider an investor with two investments that are held over a decade. Both return 10% per annum, but one delivers that 10% through growth of 5% and dividends worth a 5% yield. The other doesn't pay a dividend and just delivers its returns through earnings growth.

After ten years, our second investor will have paid no tax whatsoever, allowing their investment to compound unscathed. The other has enjoyed a stream of passive income but has had to pay taxes on every dividend received. Even if they have reinvested those dividends.

Our first investor will be in a better financial position, and have more capital to their name, at the end of the decade. At least on paper.

This is just a hypothetical exercise, of course. No share appreciates in a straight, predictable line, nor delivers guaranteed returns. However, the theory is sound. Many people need, or just want, the stream of income that an ASX dividend share can provide. But if you are young, say under 40, and are just investing in shares to build long-term wealth while you work your day jobs, it might be worth sacrificing the extra income you can receive now for what could be a more valuable investment down the road.

As such, you might wish to look for the ASX shares that are choosing to reinvest most of their earnigns back into growing their business, rather than the stocks that are throwing every dollar that they can affor into their dividned payments.

The post Under 40? Here's why buying ASX dividend shares might be a mistake appeared first on The Motley Fool Australia.

Motley Fool contributor Sebastian Bowen has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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