For those of you who invest in shares, chances are you have been sent a dividend payment (more on this later) that states whether or not the payment is ‘partially franked’, ‘fully franked’ or ‘unfranked’.
For those who are yet to invest in shares, it is wise that you read on and learn exactly what a franking credit is as it will benefit your investments greatly. Franking credits are basically related to tax; if you like paying less tax on your shares, then read on.
Either way, you are all probably asking ‘what is a franking credit?’.
You must understand dividends, before franking credits
It all starts with a dividend. A dividend is the profit a company makes that is then paid on to shareholders. This is normally paid two times a year, in the interim period and final period, if the company you are invested in decides it will indeed pay a dividend.
Note that companies do not have to pay a dividend, they can choose to reinvest the profits in the business, whether it be research and development or improving their business basics – they have the right to retain the profits to help the company grow even bigger (and in turn improve your share price).
Other companies like to return profit to shareholders in the form of dividends. This suits many Australian investors as they are looking to derive income from their shares, which allows them to be paid a couple of times a year and release cash from their investment.
For example many older Australians rely on cash dividends as a form of income in retirement. While younger investors who have more time on their hands may prefer to reinvest the dividends into more shares in the hope of seeing their investment grow with extra time and equity in the share market.
What is a franking credit?
Franking credits (also known as imputation credits) are not as complex as you are lead to believe.When you receive a dividend payment, in the form of cash or cheque, it will be for a certain amount – say $100.
Fully franked dividends
If the payment is listed as fully franked it means the company has already paid tax on the amount you are receiving, meaning you either have to pay zero tax yourself (best case) or simply just pay only a little bit more to come up to your individual tax bracket.
Most companies pay tax at a set rate of 30%, which means that your payment has been tax 30 cents for every dollar you receive, leaving you responsible for the difference between that and your tax rate.
Partially franked dividends
If the payment is only partially franked, it might mean that tax was paid for only a percentage of the payment, say 30% of the $100. This means you will have to pay tax on the other 70% of the payment ($70).
Dividends not franked at all
If the payment is not franked at all, you must pay the full amount of tax on the payment up to your tax bracket once again.
An example of how a franking credit works
For the sake of discussion, I will not go into too much boring detail here. I will keep it high level to explain franking credits as easily as possible.
You receive a dividend payment of $100 from a company. It is fulled franked, meaning tax has been paid on these earnings at a rate of 30% (that means 30 cents from every dollar has been paid in tax).
Come tax time, you hand over your dividend statements to your accountant. They will now assess the rest of your income from throughout the year and determine your tax bracket.
Once they know your tax bracket, it will determine whether the 30% tax paid on your dividends is enough, or whether you owe a little more to bring the amount of tax paid UP to your tax bracket. Remember, if your bracket falls under the 30 cents in the dollar mark, you will pay no tax. If your bracket determines you pay more, you will have to owe more tax.
Now lets use real figures, this will determine the exact tax I need to pay based on this scenario. Say you earn $40,000 per year. Based on the current ATO tax brackets, you will need to pay a flat rate of tax of $3,572 and then 32.5 cents per dollar over $37,000.
As the income is above $37,000, extra tax is owed at a rate of 32.5 cents per dollar times $3000 dollars (the amount you are over the threshold). This means extra tax of $75 is owed on your total income.
In the case of the dividend payment, as tax was only paid at 30 cents in the dollar because it was fully franked, you are required to pay 32.5 cents in the dollar, so you need to pay a little extra to meet your tax obligations.
2.5 cents x your $100 dividend payment = $2.50 you need to pay extra.
Does this make sense? If not, ask a question in the comments below and I will answer it for you.
The benefits of franking credits
Basically the more tax a company pays for you the better. It means you don’t have to pay as much tax on your investment earnings. In the case of a fully franked dividend, you are basically saving 30 cents per dollar assuming you are working and earning over $40,000 a year.
You don’t have to take dividends as cash
You can instead opt for a dividend reinvestment plan (if offered by the company) that sees your earnings reinvested into more shares under the same company. If you don’t hold a heap of shares, a dividend cheque can be so small that often it is barely worth it. This is one of the reasons people opt to reinvest it instead.
Whether you reinvest your dividends or receive them in cash is up to you. Some people wish to grow their holding of shares via a reinvestment scheme, others like to use the income generated to fund their lifestyle or utilise towards paying off debts that are costing them money (such as their house or credit card).