Franking credits might not sound exciting at first glance, but for many Australian investors, they're a hidden gem. If you're receiving dividends from ASX companies, there's a good chance you're also benefiting from franking credits without even realising their full value.
Image Source: Getty Images
Understanding the franking credit advantage
When an Australian company earns a profit, it pays corporate tax—typically 30%—before distributing dividends to shareholders. Franking credits, also known as imputation credits, reflect this tax that has already been paid.
The benefit? These credits are passed on to shareholders, helping to reduce the income tax they would otherwise owe on their dividend income. It's a system designed to prevent double taxation, ensuring investors aren't taxed twice on the same earnings.
How franking credits work in practice
Let's say a company earns $1 per share in pre-tax profit. After paying 30 cents in tax, it distributes the remaining 70 cents to shareholders as a dividend. Along with that dividend comes a franking credit of 30 cents.
When tax time rolls around, the investor declares the full $1 as income, but then gets a 30-cent credit against their personal tax bill. If their marginal tax rate is less than 30%, the ATO may refund the difference. If it's more, they simply pay the top-up.
Franking credits and 'grossed-up' dividends
When assessing the true value of a dividend, investors often look at the grossed-up yield: that's the dividend plus the franking credit, expressed as if the income was received before company tax.
For example, a 70-cent dividend with a 30-cent franking credit is effectively worth $1 of pre-tax income. If you're comparing income sources, such as interest, rent, or dividends, it's the grossed-up amount that gives the full picture.
Why does this matter now?
With proposals such as taxing unrealised capital gains on high-balance superannuation accounts, retirees may become even more interested in realised, taxable income—like franked dividends—over unrealised growth. That's because unrealised gains could be taxed annually, whether or not the asset is sold, whereas dividends come with the potential for tax credits and even refunds.
For retirees in the income phase, fully franked dividends offer not just regular payments, but also tax efficiency—an increasingly valuable feature in a changing super landscape.
A tax-friendly bonus for retirees
Franking credits can provide an additional boost for retirees, particularly those with modest taxable incomes in pension phase. If your tax rate is below the corporate tax rate, excess franking credits can even be refunded by the ATO.
It's one reason many income-seeking investors favour fully franked dividend payers like Commonwealth Bank of Australia (ASX:CBA), Wesfarmers Ltd (ASX:WES), or Telstra Group Ltd (ASX:TLS).
Not all dividends are created equal
While many companies offer fully franked dividends, not all do. Some dividends may be only partially franked or even unfranked. This can happen when:
- A company hasn't paid tax in Australia (perhaps due to losses or foreign operations)
- It benefits from tax offsets or deductions
- It earns profits in low- or no-tax jurisdictions
For example, companies like Macquarie Group Ltd (ASX: MQG) generate revenue globally and may only offer partially franked dividends. Meanwhile, real estate investment trusts (REITs) often pay unfranked distributions, as their structure typically avoids company tax.
More than just income, it's a strategy
Franking credits can play an important role in a tax-efficient investing strategy. For income-focused investors—particularly those in lower tax brackets or super funds in pension mode—franked dividends can enhance after-tax returns.
While it's tempting to chase high yields, don't overlook the tax treatment. A slightly lower yield with full franking might deliver a better net return than a higher yield that's unfranked.
As always, tax rules can change, so it's wise to stay informed and speak with a qualified adviser if you're incorporating franking credits into your long-term planning.
Foolish Takeaway
Franking credits are one of the unique advantages of investing in Australian dividend stocks. Whether you're a retiree looking to maximise passive income or a long-term investor aiming for tax-smart returns, understanding how franking works could help make every dollar count.
