It’s obvious that investors select investments based on the rate of return they can earn on their funds. For share investments, the rate of return has two components:
1 – Sell the share for gain. Assume you purchase 100 shares $20 each. If you later sold the shares for $40 each you have made a capital gain of $20 per share. The total gain is $2,000 ($20 for each share) on the original 100 shares;
2 – Earn a return through a dividend. A dividend is a share of company earnings paid to the shareholder. If your share pays a $1.50 on each of your 100 shares, you’ll earn $150.
Keep in mind that your rate of return should be based on the dollars you keep after taxes have been paid. One way to reduce the tax you pay on dividends is by using franking credits.
How do they work?
Franking credits are a tool used by investors to reduce or eliminate the taxation of dividends. Australian companies that pay dividends to shareholders can be subject to double taxation. The earnings are taxed to the corporation rate of 30%. If earnings are then paid to shareholders in the form of dividends, they are taxed again at the individual’s personal tax rate.
A franking credit is a tax credit allocated to the shareholder. The tax credit can offset the tax that is due on the dividend.
Assume you receive a $100 dividend and your tax rate is 34.5%. The company has already paid 30% tax on its profit. A franking credit of $30 ($100 x 30%) would reduce your tax liability leaving only 4.5% of the dividend income taxable.
That example applies if the dividend is fully taxed or “fully franked” at 100%.
A partially franked dividend means that the tax credit only covers a portion of the taxable dividend payment. However, even a partially franked dividend increases your rate of return.
Assume that the franking credit only covers $20 of the $30 in tax. You’re still ahead because you’ve earned $100 – $10 in taxes, or $90.
Reinvesting + Compounding
If you are able to earn more dividend income after tax and reinvest that income, you can also benefit from compounding. Compounding is defined as earning “interest on interest”.
Assume that you’re able to invest the full $100 dividend, rather than just $90. With compounding, that extra $10 in dividends will earn a return. Over time, reinvesting more dividends can greatly increase your total earnings.
The looming Federal Election may result in changes to the dividend imputation system, with the Labor Party promising to abolish in full, cash refunds for excess franking credits for the majority of Self Funded Retirees, who manage their retirement savings within a Self Managed Superannuation Fund.
Many investors benefit directly from Franking Credits on dividends. To find out more, or to put a plan in place to negate a possible loss in Franking Credit Refunds, why not give us a call.
Intrinsic Private Wealth specialise in providing financial advice to Australian investors. With over 20 years of experience in the finance & investment industry.
General Advice Disclaimer: Information is of a general nature only and has been provided without taking account of your objectives, financial situation or needs. Because of this, you should consider whether the information is appropriate in light of your particular objectives, financial situation and needs. Intrinsic Private Wealth has financial advisers that are authorised to provide personal financial advice. Call 02 9615 4500 for more information on our available services.