If you’re interested in dividends shares, or you’ve followed the 2019 election, chances are you’ve heard of the word “franking credits”. It’s one of the things that Australian investors love the most about the stock market. But do you know what franking credits actually are and what can you do with them?
What Are Franking Credits?
Franking credits, also known as imputation credits, are a unique feature of the Australian tax system to avoid double taxation on company earnings paid as dividends. They represent the tax paid by a company on its profits before distributing dividends to shareholders. Understanding franking credits is crucial because they can boost the overall return of your portfolio.
Types of franking credits:
- Fully franked – 30% tax has already been paid before the investor receives the dividend.
- Partly franked – 30% tax has already been paid on the FRANKED part of the dividend, and no tax has been paid on the UNFRANKED part.
- Unfranked – No tax has been paid.
How Do Franking Credits Work?
Here comes the next question: What do you do with franking credits?
From an investor’s point of view, they can use those credits to offset taxable income, but in some cases (such as superannuation), part of the franking credits might be paid back to you as a refund.
It can be complicated, so let’s break it down with a simple example:
- Company tax rate in Australia is 30%
- Suppose BHP pays a fully franked dividend of $1,000 to a shareholder.
- To pay this $1,000 fully franked dividend, BHP must earn $1,428.57 before tax.
- In this scenario, with gross dividends of $1,000, you also receive franking credits of $428.57 from BHP.
Here’s a table that illustrates the impact of franking credits at various tax rate brackets:
| Tax Rate (%) | Gross Dividends ($) | Franking Credit ($) | Tax ((Dividends + Franking Credit) * Tax Rate) | Net (Dividends + Franking Credit – Tax) |
|---|---|---|---|---|
| 15% | $1,000 | $428.57 | $214.29 | $1,214.29 |
| 30% | $1,000 | $428.57 | $428.57 | $1,000 |
| 40% | $1,000 | $428.57 | $571.43 | $857.14 |
| 50% | $1,000 | $428.57 | $714.29 | $714.29 |
The table demonstrates how different tax rate brackets affect the tax liability and net income after considering franking credits.
Notes: This is one of the reasons Australian shares are popular in super funds that are taxed at 15%.
Consulting a tax professional can provide personalized guidance on optimizing franking credits based on an individual’s specific financial situation.
Are They Always Good?
There’s no doubt that franking credits can be a valuable benefit for Australian investors. However, there’s no one-size-fits-all solution, especially when it comes to investing. Keep in mind that franking credits may not always suit every investment strategy or individual circumstance. Here are some points to consider:
- Tax Rate Variability: The effectiveness of franking credits depends on your individual tax rate. If your tax rate is lower than the corporate tax rate, franking credits can lead to tax refunds. However, if your tax rate is higher, the benefit may be less pronounced.
- Investment Objectives: Consider your investment goals. If you’re seeking regular income and tax efficiency, fully franked dividends can be an excellent choice. However, if you prioritize capital growth and are comfortable with a lower dividend yield, you might focus on growth-oriented investments.
- Diversification: Overreliance on fully franked dividends from a specific sector or industry can lead to a lack of diversification in your portfolio. It’s crucial to maintain a balanced and diversified investment strategy to manage risk effectively.
Conclusion
Franking credits are a special feature of Australia’s tax system, aiming to prevent double taxation on dividends. They play a significant role in your investment returns, depending on your tax rate. While they offer valuable benefits to many Australian investors, it’s important to tailor their use to your specific financial goals and investment strategy.
We understand that everyone is unique, and we take pride in assisting our clients in establishing a diversified portfolio that aligns with their individual demands and circumstances. Book your free consultation with us to get started investing.
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