Futuro explains the benefits of franking credits in your portfolio.
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:
- 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 gain of $20 per share. The total gain is $2,000 ($20 for each share) on the original 100 shares;
- Earn a return through a dividend. A dividend is a share of company earnings paid to the shareholder. If your share pays $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?
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”.
A partially franked dividend means that the tax credit covers only 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.
Speak to our Wealth Management experts about how franking credits can benefit your portfolio.