If you invest in a company that pays dividends , you may have noticed that some are “franked”. But you might also be a little unsure as to what this means. In this article, we’re demystifying the concept for Aussie investors by looking at how they work, how to calculate them, and their potential benefits.

As you read through this article, keep in mind that it’s designed to be an informational piece on franked dividends – not financial or tax advice. Given that franked dividends pertain to your tax situation, never hesitate to reach out to a licensed financial adviser or tax accountant for personalised guidance.

What are franked dividends?

Franked dividends are a unique feature of the Australian taxation system designed to prevent double taxation on company profits.

Here’s how they work: when a company makes a profit, it pays corporate tax on that profit. The after-tax profits can then be distributed to shareholders as dividends . What makes franked dividends unique is that they come with a franking credit , reflecting the tax the company has already paid. Shareholders can use this credit to offset their own tax liabilities , creating a more efficient tax situation.

Imagine a company distributes a $70 dividend with a $30 franking credit. This shows the company paid $30 in tax on a return of $100 in total. Shareholders can use this $30 franking credit to reduce their tax on the dividend income. Essentially, they may get credit for the tax the company has paid, potentially lowering their overall tax burden.

What's the difference between a fully franked and a partially franked dividend?

Now, not all franked dividends come with the same tax benefits. "Fully franked" and "partially franked" are key terms that reflect the level of tax already paid by a company on its profits before distributing dividends .

A fully franked dividend means the company has paid the full 30% corporate tax rate on the profits being distributed. This dividend comes with franking credits covering the entire amount, making it more tax-efficient.

For instance, if you receive a $70 fully franked dividend, it comes with a $30 franking credit. This credit can be used to offset your tax liability, ensuring you're not taxed twice on the same income.

On the other hand, partially franked dividends mean the company has paid less than the full corporate tax rate on the profits. As a result, only part of the dividend carries franking credits.

For example, if a company pays a $70 dividend with a $15 franking credit, it indicates that the tax paid was partial. Shareholders receive a smaller franking credit, offering less tax relief.

Can dividends be unfranked?

Then there are unfranked dividends. Unfranked dividends are distributions paid to shareholders without any attached franking credits. This means the company hasn’t paid tax on the profits used for these dividends. Shareholders must pay their full marginal tax rate on unfranked dividends, potentially resulting in a higher tax liability compared to franked ones.

How can franked dividends benefit Aussie investors?

Franked dividends can offer several potential advantages, making them a consideration for some investment strategies. Here’s how they could benefit Aussie investors:

• Tax efficiency
  As mentioned above, franking credits attached to dividends can be used to offset your personal tax liability, possibly reducing the amount you owe. If the franking credits exceed your tax liability, you might even receive a refund from the Australian Taxation Office (ATO). This can be particularly beneficial for retirees and low-income earners.
• Enhanced returns
  By lowering the tax burden, franked dividends can boost the effective yield on your investments. This can make dividend-paying shares more attractive, potentially leading to higher overall returns.
• Attractive for self-managed super funds (SMSFs)

  SMSFs in the pension phase could benefit from franking credits. Since they pay no tax on income, they can receive a full refund of franking credits. This may lead to higher net returns and a more robust retirement nest egg.

• Incentive for long-term investment

  Companies that pay franked dividends are often financially stable and profitable, making them worth consideration for long-term investment . Holding such shares could lead to consistent income and capital growth over time. However, franked dividends are by no means a guarantee of robust financial performance, and investors should always research other factors before making a decision.

• Diversification of income

  Investing in dividend-paying shares may provide an income stream, diversifying your sources of income . This may be useful during market downturns when capital gains might be harder to achieve.

• Lower tax rate for certain investors

  Investors on lower marginal tax rates can sometimes benefit more from franking credits, as the credit may fully offset their tax liability. This can result in tax-free or even tax-positive income.

• Encourages equity investment

  The franking system incentivises investors to hold shares in Australian companies, supporting local businesses and the economy.

Are there any other considerations with franked dividends?

While franked dividends offer numerous potential benefits, there are some potential drawbacks to consider:

• Limited to Australian companies

  Franked dividends are only available from Australian companies, which may limit diversification opportunities in international markets .

• Dependence on company profitability

  The availability of franking credits depends on the company’s profitability and tax payments. Economic downturns or company-specific issues can reduce dividend payouts and franking credits.

• Complexity in taxation

  The franking credit system can be complex and may require a deeper understanding of tax rules. It’s absolutely worth seeking out advice from a tax accountant if you need help navigating franked dividends and your taxes.

• Changes in tax policy

  Government policies on franking credits can change, potentially reducing their attractiveness. For instance, proposals to limit or remove franking credit refunds could impact returns for certain investors.

• May not be efficient for all investors

  Investors in higher tax brackets might find less benefit from franking credits compared to those in lower brackets or retirees.

How can I calculate a fully-franked dividend yield?

Calculating a fully-franked dividend yield involves a few simple steps:

1. Determine the dividend: Find the total annual dividend per share paid by the company.
2. Find the share price: Obtain the current market price of the share.
3. Calculate dividend yield: Use the formula:
   
4. Include franking credits: Multiply the dividend by 1.428 (to account for the 30% tax credit):
   

This gives you the fully-franked dividend yield, reflecting the total pre-tax return.

Alternatively, you can do away with fussy formulas and head straight to Pearler’s Franking Credits Calculator . This nifty tool helps you figure out the value of your franked dividends in relation to your income tax bracket.

Franked dividends – a case study

Here’s a hypothetical case study on how franked dividends could be beneficial. Bear in mind that it doesn’t reflect what might happen in reality and is purely for illustrative purposes.

Sarah, a semi-retiree and keen investor, puts her money into in an Australian company paying fully franked dividends. She owns 1,000 shares, with the company distributing an annual dividend of $2 per share, totalling $2,000.

With a 30% franking credit, Sarah receives an additional $857 in franking credits. Since she’s in a low tax bracket, Sarah uses the franking credits to reduce her tax liability, and the excess $857 is refunded to her. This boosts her effective return and increases her total income to $2,857.

A final word on franked dividends

Franked dividends can be a great part of your share investing portfolio, potentially offering positive returns and tax benefits. But remember that taxes can be complex, and returns are never guaranteed.

Do your research before making any kind of investing decision. And, as we always say, reach out to a professional – be it a financial adviser or tax accountant – if you have specific questions or concerns.

Happy investing!