As a financial advisor based in the beautiful land down under, I’ve noticed that many Australians aren’t taking full advantage of one of our tax system’s unique benefits: franking credits. Today, I’m going to break down this often misunderstood concept and show you how to maximise your dividend returns.
What Are Franking Credits?
Simply put, franking credits are tax credits attached to dividends that companies pay to their shareholders. When an Australian company pays tax on its profits and then distributes some of those already-taxed profits as dividends, it can pass on the tax it has paid as franking credits to shareholders.
These credits represent the amount of tax the company has already paid on your behalf. The purpose? To prevent double taxation, where both the company and you as the shareholder pay full tax on the same income.
How Do Franking Credits Work?
Let’s break this down with a straightforward example:
- Company XYZ earns $100 in profit
- It pays $30 in corporate tax (30% rate)
- It decides to distribute the remaining $70 as a dividend to you
- Along with this $70 cash dividend, you receive a $30 franking credit
When tax time comes around:
- You must declare both the $70 cash dividend AND the $30 franking credit as income ($100 total)
- The $30 franking credit is then applied against your tax liability
- If your marginal tax rate is less than 30%, you’ll receive a refund for the difference
- If your rate is higher than 30%, you’ll only need to pay the difference
Why Franking Credits Are a Game-Changer
For retirees and low-income earners, especially, franking credits can be incredibly valuable. If your tax rate is below the company tax rate, those excess franking credits are refunded to you – actual cash back in your pocket!
Even for higher-income earners, franking credits reduce your effective tax on dividend income, boosting your after-tax returns compared to other investments without franking.
Strategies to Maximise Your Franking Credits
1. Focus on Fully Franked Dividends
Not all dividends come with franking credits, and some are only partially franked. Look for companies that pay fully franked dividends – these provide the maximum tax benefit.
2. Time Your Investments Strategically
To receive franking credits, you must hold the shares for at least 45 days around the dividend payment date (the 45-day rule). Plan your investments accordingly to ensure you qualify.
3. Consider Your Tax Bracket
Franking credits provide the greatest benefit when there’s a significant difference between the corporate tax rate and your personal tax rate. This makes them particularly valuable for self-managed super funds in the pension phase (0% tax rate) and individuals in lower tax brackets.
4. Diversify Across Dividend Payers
Don’t put all your eggs in one basket. Spread your investments across different companies that pay franked dividends to manage risk while still capturing the tax benefits.
5. Look Beyond the Big Banks
While the major banks are known for their franked dividends, many mid-sized Australian companies also offer fully franked dividends, sometimes with higher yields or growth potential.
Common Misconceptions About Franking Credits
Let’s clear up some confusion:
- Myth: Franking credits are just for wealthy investors. Reality: They benefit all Australian taxpayers, particularly those on lower incomes.
- Myth: The higher the franking percentage, the better the investment. Reality: Investment quality should be your primary consideration – franking is a bonus.
- Myth: Foreign investors get the same benefits. Reality: Franking credits generally only benefit Australian tax residents.
Real-World Impact for Small Business Owners
As a small business owner, understanding franking credits isn’t just relevant for your personal investments. If your business is structured as a company, knowing how dividend imputation works can help you make more tax-efficient decisions about how and when to distribute profits to yourself and other shareholders.
Final Thoughts
Franking credits are a uniquely Australian advantage that can significantly boost your investment returns. By understanding how they work and implementing strategies to maximise their benefits, you can make your money work harder for you.
Remember, while tax benefits are important, they should never be the sole reason for an investment decision. Always consider the underlying quality of the investment, your overall portfolio strategy, and your personal financial goals.
Written by Michael Andrew Bankier