One of the most common questions I hear from ASX dividend share investors is around how to build a portfolio that can provide tax-advantaged income.
The way our dividend system is structured in Australia is actually fairly unique in the world – and gives investors the opportunity to harvest income in an advantaged way.
But many investors don’t realise this and make decisions with their investing which negate these benefits and can even end up eroding their overall returns.
So let’s look at how ASX shares are taxed, and how you can use this to your advantage. Remember though – this is just general information. You should always speak to a tax professional about your individual circumstance as well.
How are ASX shares taxed?
When you own ASX shares you will face two types of tax: capital gains tax and income tax.
Capital gains tax is only levied when you buy an ASX share and sell it at a later date for a profit. In most circumstances, you get a discount on this gain if you have held the shares longer than a year. And if you never sell a share, you never have to pay tax on its gains – something to keep in mind.
For shares that don’t pay dividends, that’s the end of the story. But if you hold shares that do (which is likely for many ASX investors), you will also pay income tax.
See, dividends are taxed as ordinary income. This means you’ll have to add the dividends you receive each year to your total income, which is then taxed at your marginal rate.
But there’s another aspect to dividend taxes that some investors overlook: franking credits.
How franking can help you pay less tax
If a company pays a dividend in Australia, it usually does so from a pool of cash that has already been taxed by the government. Therefore, if the government taxes the dividend again when you receive it as income, it will have been taxed twice. To remove this double-tax, the dividend will come with a ‘receipt’ of the tax that’s already been paid. That receipt is known as a franking credit. Depending on how the company has paid its tax, and in which country it earns its income, dividends may be distributed fully franked, partially franked or with no franking credit at all.
Franking credits can be used to offset other income as a deduction, effectively reducing the tax you have to pay on said income. In this way, receiving dividends is a very tax-effective way to make money. This is particularly relevant in retirement when you no longer have work-related deductions to offset your income tax.
Of course, some investors don’t really worry about dividends and prefer to stick with growth shares to try and maximise capital gains. But for those investors who invest for income, or even those who are happy with any kind of return, dividends can be a great way to receive income that comes with tax advantages like franking. So make sure if you invest for dividends, you know the full extent of the benefits that come with them!
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Motley Fool contributor Sebastian Bowen has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.