In today’s article we discuss how franking credits in your self-managed super fund (SMSF) can be used to boost your returns, and we provide a guideline of what you should consider when investing for dividends in your super fund.
SMSF investors should be investing in income-producing investments as well as investments that are likely to increase in capital value. When you are investing in shares for income through dividends an added benefit is that franking credits are often attached to the dividends you receive. Franking credits stop the double taxation of company profits, as the tax paid at the company level can be passed on to its shareholders.
A franking credit is your share of tax paid by a company on the profits from which your dividends or distributions are paid. These credits, also known as imputation credits, are a type of tax credit that allows Australian companies to pass on tax paid at the company level to its shareholders and the credits can be used to reduce your income tax. Any remaining credits can potentially be received as a tax refund. Depending on the investor’s marginal tax rate, they will either owe a lower amount of tax or receive a refund.
The real benefit from franking credits comes to you at tax time. When you prepare your tax return, you need to include both the dividend and the attached franking credit in your assessable income.
How Do Dividends and Franking Credits Work?
The cashflow of the credits is illustrated below. For a company that generates a profit of $1000, the tax paid will be $300 (at the 30% company tax rate). This leaves the company with $700 profit after tax. The company can choose to use these funds as retained earnings and reinvest the money back into the business or pay out the profit to its shareholders in the form of dividends. In this example we assume the company has paid a $700 dividend to its shareholders.
FIGURE 1: The cashflow for franking credits.
After the shareholder receives the $700 dividend he/she is entitled to the $300 franking credits at the ATO and therefore the total assessable income or “grossed up” dividend is $1000. The shareholder’s marginal rate will determine if they have to pay the ATO additional tax or potentially receive franking credits back as a tax refund.
Fully Franked Dividend Calculation
The formula to calculate franking credits (assuming they are 100% franked) is:
Franking Credits = [(Dividend Amount / (1-Company Tax Rate)) – Dividend Amount] * Franked%
For our example with a $700 dividend that is 100% franked:
Franking Credits = [($700 / (1 – 0.30)) – $700] *100%
= [($700 / 0.700) – $700] *100%
= [$1000 – $700] *100%
Gross Up Dividend
The ‘gross up dividend’ means that you are including the franking credits in your return on investment (ROI). It is essential to use your grossed up dividends in the your return calculations. In this example you received a $700 dividend, but you are entitled to the additional $300 in franking credits, making your total assessable income $1,000. If your tax rate is 30%, you get to keep the $700 and will not have to pay tax on it as the company has already paid 30% company tax.
Note when you are comparing a dividend to a cash or term deposit, you have to compare the grossed up dividend to compare like-for-like, because some tax is already paid for you on a franked dividend, where as no tax has been paid on the interest from cash or a term deposit.
45-Day Holding Rule
In order to be eligible to receive franking credits you need to hold you shares at risk for over 45 days. This does not count the purchase and sale dates so in effect it is a 47-day holding period. More information on this rule can be found on the Australian Taxation Office Website – Australian Taxation Office Franking Credit Rules.
How Do Franking Credits Affect Your Overall Tax?
The impact of franking credits on your overall tax depends on your marginal tax rate. You will even receive a tax refund on the dividend income if your marginal tax rate is less than the company tax rate of 30%.
Where your marginal tax rate is more than 30%, you need to pay tax on the dividend income. However, the tax you need to pay will be at a much lower rate than your marginal tax rate. If you are in the top tax bracket (at 46.5%), only an additional $165 tax is payable when you receive the $700 dividend. In comparison, if you receive the same $700 from another type of investment income, such as interest from a term deposit, you will need to pay $325 income tax if you are on the top marginal tax rate.
NOTE: This example is illustrative only and you should consult a tax professional to determine the effects of dividends or franking credits on your individual tax.
Juice Up Your SMSF Returns Using Franking Credits
Now here’s the big advantage when you qualify for franked dividends in your SMSF. After the tax credits are passed on to the investor (the SMSF in this case) they can be utilised to reduce the tax payable by the fund. Also, if the franking credits are larger than your SMSF’s tax bill, your super fund will generally receive the excess credits in the form of a tax refund from the ATO once you lodge your super fund tax return.
Remember that the maximum superannuation earnings tax rate is 15% and when in the pension phase (retirement phase) the tax rate is 0%. (This may change in the future, given the latest reforms on taxing pension assets that earn above $100,000 per annum, refer to the ATO website for more details). This means that when your super or pension funds receive franked dividends, the excess franking credits can be refunded to your super or pension accounts to boost the overall earnings.
So if your SMSF receives a fully franked dividend (a tax credit of 30%) the franking credit is incredibly useful in not only offsetting the super tax payable from the dividend or distribution, it can also have the effect of offsetting taxes paid by other income earned by your self managed super fund such as interest income and concessional contribution tax. Additionally the ATO will refund any excess above this to your SMSF.
Please note the information provided in this article is general in nature and you should consult with an SMSF accountant or financial adviser in relation to using franked shares in your SMSF.
Investing in your SMSF super fund for income should be treated as a business and these are just some of guidelines that you could consider to boost your SMSF super fund investment returns. You might also refer to our previous article, Investing in Dividends in Your SMSF.
The secret to above average returns in your SMSF is measureable performance, consistency of returns and income, time and the power of compounding!
We here at D2MX Advisory can assist you with taking action to invest for the dividend season and we have strategies designed specifically to generate consistent income and returns. Contact us at 1300 610 024 or email firstname.lastname@example.org.
The market has provided some excellent opportunities this year. There are a number of dividend investment opportunities setting up right now, that you could potentially profit from. If you would like more information please contact me at call 1300 610 024 or email email@example.com.
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Investment Adviser – D2MX Advisor
Also in this series:
Part 1: Boosting Dividend Yield in Your Self-Managed Super Fund (SMSF)
Part 2: Compounding in Your Self-Managed Super Fund
Part 3: Post-Election Investment Opportunities
Part 4: Simple Breakout Finder for Your Self Managed Super Fund
Part 5: Simple Trade Signal Setups for Your SMSF
Part 6: Protecting Your Self Managed Super Fund
Part 7: Investing For Profit in Your Self-Managed Super Fund
Part 8: Tracking Profits in Your Self-Managed Super Fund
Part 9: Investing in Dividends in Your Self-Managed Super Fund
This report was prepared by Michael Hevern, Authorised Representative of D2MX Pty Ltd (AR 417348). It represents the views and opinions of the author. It is not intended for use by any third party, without the approval of Michael Hevern. While this report is based on information from sources which are considered reliable, its accuracy and completeness cannot be guaranteed. Any opinions expressed reflect my judgment at this date and are subject to change. Contracting Hevern Pty Ltd is a Corporate Authorised Representative No. 408868 of D2MX Pty Limited ABN 98 113 959 596, AFSL No. 297950 (D2MX), and Michael Hevern has been appointed as an Authorised Representative of Contracting Hevern Pty Ltd. Opinions, conclusions and other information expressed in this report are not given or endorsed by D2MX, unless otherwise indicated. The information contained in this Report is General Advice only, as the information or advice given does not take into account your particular objectives, financial situation or needs.
Disclaimer: Using leverage to invest can be a two edged sword, as it can magnify your returns when the stock price rises, but will in turn magnify the losses if the trade does not perform as expected.