Franking Credits 101: What Every Australian Investor Should Know
Franking credits are a unique feature of the Australian tax system that can significantly enhance the returns on your investments. Understanding how franking credits work and how to maximise their benefits is essential for any Australian investor. This comprehensive guide will explain the concept of franking credits, their advantages, and strategies to optimise their use in your investment portfolio.
What Are Franking Credits?
Franking credits, also known as imputation credits, are tax credits that Australian companies attach to dividends paid to shareholders. These credits represent the tax that the company has already paid on its profits. When shareholders receive dividends, they can use the franking credits to offset their own tax liabilities, preventing the same income from being taxed twice.
How Do Franking Credits Work?
When an Australian company earns a profit, it pays corporate tax on that profit at the current rate of 30%. If the company decides to distribute some of this profit to its shareholders as dividends, it can also pass along the benefit of the tax it has already paid in the form of franking credits.
For example, if a company pays a $70 dividend with a 100% franking credit, it means the company has already paid $30 in tax, making the total taxable income $100. Shareholders must declare both the dividend and the franking credit on their tax returns. The franking credit then offsets the tax payable by the shareholder. If the shareholder’s tax rate is lower than the corporate tax rate, they may receive a tax refund for the difference.
Benefits of Franking Credits
Franking credits offer several advantages for Australian investors:
- Tax Efficiency: Franking credits help avoid double taxation, making dividends more tax-efficient compared to other forms of investment income.
- Increased After-Tax Income: For shareholders in lower tax brackets, franking credits can lead to significant tax savings or refunds, increasing after-tax income.
- Enhanced Returns: Franked dividends can boost the overall return on investment, especially for retirees and super funds with lower tax rates.
- Investment Attraction: Companies that pay fully franked dividends are often more attractive to investors seeking tax-efficient income.
Franked vs. Unfranked Dividends
Dividends can be either “franked” or “unfranked”. Franked dividends come with franking credits, indicating that the company has already paid tax on the profits distributed. Unfranked dividends have no franking credits attached, meaning the shareholder must pay the full tax on the dividend income.
Maximising the Benefits of Franking Credits
To make the most of franking credits, consider the following strategies:
1. Invest in Companies with High Dividend Yields
Look for companies that consistently pay high, fully franked dividends. These companies often have strong, stable earnings and a commitment to returning profits to shareholders.
Examples:
- Commonwealth Bank of Australia (ASX: CBA)
- Telstra Corporation (ASX: TLS)
- Wesfarmers Limited (ASX: WES)
2. Utilise Dividend Reinvestment Plans (DRPs)
Participating in DRPs allows you to reinvest your dividends into additional shares, compounding your returns over time. Many DRPs also offer shares at a discount and without brokerage fees.
3. Consider Exchange-Traded Funds (ETFs)
ETFs that focus on high-dividend Australian stocks can provide diversified exposure to companies paying fully franked dividends. For example, the BetaShares Australian Dividend Harvester Fund (ASX: HVST) aims to provide high, tax-effective income through dividends and franking credits.
4. Leverage Superannuation Funds
Super funds benefit significantly from franking credits due to their lower tax rates. In the accumulation phase, super funds pay 15% tax, and in the pension phase, they pay no tax. Excess franking credits can be refunded, effectively boosting the fund’s income.
5. Maintain Accurate Tax Records
Keep detailed records of all dividend payments and franking credits received. This will ensure you can accurately claim the credits on your tax return and maximise your tax benefits.
Case Study: The Power of Franking Credits
Consider an investor in the 19% tax bracket who receives a $70 fully franked dividend. The franking credit is $30, making the total taxable income $100. The tax payable on $100 at 19% is $19. The $30 franking credit offsets this tax, resulting in a $11 refund ($30 – $19). This effectively increases the investor’s after-tax income.
Franking credits are a powerful tool for Australian investors, offering significant tax advantages and enhancing investment returns. By understanding how franking credits work and implementing strategies to maximise their benefits, you can optimise your investment portfolio and achieve better financial outcomes.
Whether you are a retiree, a super fund investor, or simply looking to boost your income, leveraging franking credits can provide a substantial advantage. Always consider seeking advice from a qualified financial advisor to tailor these strategies to your personal circumstances and ensure you are making the most of your investments.