Let’s go right back. The year is 1987. What a year it was. Carlton won the VFL Grand Final, I was born, and our then Treasurer Paul Keating introduced this exciting thing (if you’re a finance nerd like me) called ‘Franking Credits’.
A franking credit is a tax credit that can be used to offset taxes in an individual’s tax return. It’s your share of tax paid by a company on the profits from which your dividends or distributions are paid.
Prior to the franking credits system being introduced, the ATO would tax companies on their profit and shareholders were taxed on dividends received. This was double dipping in action.
How franking credits prevent tax double dipping
This can get a bit technical, so I’ll break it down by starting with how dividends work:
- If you buy shares in a company (ABC Company Ltd), ABC Company will conduct a business of some sort and generate ‘revenue’.
- After paying some costs they generate ‘profit’.
- ABC Company then has to pay tax on that profit.
- After paying tax they’ll generally reinvest into the business to hopefully increase ‘revenue’ and profit further, but they’ll also pay some out to shareholders in the form of ‘Dividends’ (You are entitled to this as a shareholder in a business).
Here is where the magic happens
- The tax magic comes because these dividends are paid from profit after tax has been paid.
- Since the introduction of the Franking Credit System, when you receive your dividend, it comes with a tax credit attached.
- This tax credit is applied to your other income, so you can reduce the overall tax you pay on your total income.
- For people with lower tax rates or nil-tax, franking credits can result in tax refunds and boost after-tax income from dividends.
Less = More with fully franked shares
If your investment portfolio is full of Australian Shares that are ‘fully franked’ your after-tax investment income will be higher with a lower portfolio balance.
This helps fast-track your progress toward financial freedom.
Let’s run through an example to show this in practice.
Let’s assume the following:
- You invest $500/w into Australian Shares that pay fully franked dividends.
- The dividend return on these shares is 4.5%.
- We’ll assume capital growth of 4% (which I’ve knocked back from fees, tax and inflation) and tax paid on those shares at the company rate of 30%.
Your outcome could look as follows:
You can see from the table above that, much like compounding your portfolio balance, your tax credits compound too.
Your benefits grow into the future when you follow this strategy to an annual tax benefit of $15,555 by year 20 of the strategy.
Franking credits mean you need less for the same income
If we look at a comparison of having your investment income made of franked dividends vs unfranked dividends, assuming your aim is to replace around $90,029 (Gross or pre-tax) of income (which is close to the average income in Australia at the time of writing).
- Tax payable on this average income is around $22,247, leaving you with a ‘net’ income of around $69,782.
NB: This is based on the FY23-24 Tax Rates in Australia. - If you were to replace this income with unfranked dividends, you’d need to replace the entire $92,029 and then pay at your Marginal Tax Rate to be left with $69,782 after tax.
- But if you build a fully franked dividend income with tax paid at the company rate of 30%, you’d only need to receive dividends of $64,421, which would come with attached tax credits of $27,609.
You’d end up with the same amount of income after tax, but need less headline income (and therefore wealth) to get to the same position.
Or if you consider this through another lens. To generate after-tax income of $64,421, assuming a 5% total income rate:
- If this income was made up of fully franked dividends, you need an investment portfolio balance of $1,288,420.
- Alternatively, if your portfolio is made up of unfranked dividends or other income without franking attached you’d instead need an investment of $1,840,580.
In essence, you can have $522,160 less in investments and receive the same income, meaning you’re essentially just as wealthy with less tax.
This is the power of tax planning.
The nitty gritty
Now if you’ve got a keen eye for detail, here’s the formula for calculating Franking Credits:
Franking Credit = (dividend amount / (1-corporate tax rate)) – dividend amount.
Or
Franking Credit [$27,609] = (dividend amount [$64,421] / 1-company tax rate [30%])) – Dividend Amount [$64,421].
Other key points:
- You don’t need to do anything to collect franking credits other than invest in Australian companies (which can be done via an ETF or Index Fund).
- Franking Credits are only available for companies listed on the Australian Stock Markets.
- Franking Credits are a great tool, but you still need to consider ‘spreading your risk’ through diversification.
- Australian Shares only make up a small proportion of global share markets.
- In a perfect world, you’d have a mix of Australian and International shares so you benefit when Australian and Global Markets are performing.
- That said, if tax savings are important, a tactical tilt toward Aussie shares should be considered.
Any questions?
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Cheering you on!
Certified Financial Planner®, Director
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Important:
This is not tax advice. Your personal objectives, needs or financial situation have not been considered when preparing this information.
The information contained in this update has been provided as general advice only. The contents have been prepared without taking account of your personal objectives, financial situation or needs.
You should seek advice before making any decision regarding any information, strategies or products mentioned to consider whether that is appropriate to your own objectives, financial situation and needs.
Current as of 5 March 2024.