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 (Capital Growth component) – assume you purchase 100 shares at $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 (Income component) – 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 at 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 profits. 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.
Many investors can benefit from franking credits on dividends. To find out more, give us a call.