How franking credits can boost your return in retirement

Woolworths recently announced a dividend of 47 cents per share, payable on April 11, that will be ‘fully franked’. So, an investor who owns 1,000 shares will receive $470 in cash and, as an additional benefit, $201.43 in franking credits. But what exactly are franking credits and how does this all work? Let’s take a look.

What are franking credits?

Franking credits are a tax credit often included with the payment of dividends from Australian companies. Commonly owned companies such as Commonwealth Bank, Telstra, Woolworths and Wesfarmers have a history of paying dividends that include franking credits.

It is important to note that not all dividends are ‘fully franked’. Some companies will pay dividends with no franking (unfranked) while others will pay partly franked dividends.

If you value the benefit of franking credits, it might be worth looking at the company’s history to see whether they have been paying fully franked, partly franked or unfranked dividends. 

What do franking credits exist?

The goal of a franking credit system is to stop the ‘double taxation’ of company dividends – where dividends are taxed at both the company level, and then as income when they are paid to investors as dividends. 

Importantly for investors, and particularly those retired or thinking about retirement, excess franking credits are refunded through the tax system. 

How do franking credits work?

One way to understand how franking credits work is to compare an unfranked dividend with a fully franked dividend. To do this, let’s go back to the way the Australian taxation system worked before franking credits were introduced and look at the cash flow to an investor.

Let’s assume a company earns $100 and decides to pay that as a dividend. The company pays tax at the rate of 30%. After the company pays $30 tax, $70 remains and is paid to the investor as a dividend. 

The investor has to add the dividend to their taxable income and pay tax. Someone on a tax rate of 32.5% will have to pay $22.75. As you can see from the table below, after paying tax the investor will have $48.25 to spend. 
 

Dividend with no franking credits

The ‘double taxation’ refers to the fact that both the company and the investor paid tax on the $100 of earnings. 

Let’s consider the same scenario, only this time with the opportunity for the company to pay a fully franked dividend – the current system in Australia. Once again, the company earns $100 and decides to pay that as a dividend. 

The company pays tax at the rate of 30%. After tax, $70 is paid to the investor as a dividend.  However, with the franking credit tax system the company can pay a fully franked dividend, allowing the investor to receive both the $70 cash and a $30 franking credit. 

The investor is required to add the dividend and franking credits to their income and pay tax on that amount. In this example, they must add $100 to their income. So someone on a 32.5% tax rate has to pay $32.50 in tax.  

They also have a $30 prepayment of tax in the form of franking credits that reduce their tax. Given that they have to pay $32.50 in tax and have $30 in franking credits they only have to pay a further $2.50 in tax. After paying tax, the investor will have $67.50 to spend. 

Dividend with franking credits

The bottom line? An investor on a 32.5% tax rate receives around 40% more value from their dividends after tax compared to a tax system without franking credits. 

Franking credits in retirement

The benefits of franking credits get even better in retirement. Most people in retirement face a 0% tax rate, through having only modest income in their own name and using a superannuation fund paying a pension that is tax-free. In this situation, retirees receive the franking credits as a tax refund.

So let’s say a company earns $100 and decides to pay that as a dividend to an investor who is retired, and does not pay income tax or tax in their superannuation fund.

The company pays tax at the rate of 30%. After tax, $70 is paid to the investor as a dividend.  However, with franking credits the investor also receives $30 in ‘franking credits’ – effectively a pre-payment of tax. In total, the investor receives $70 cash and $30 in franking credits. 

The retired investor must add the dividend and franking credits to their income and pay any tax.  Because the retiree has a 0% tax rate, it means they have no tax to pay.  However, they also have a $30 prepayment of tax in the form of franking credits. They (or their superannuation fund) will receive this $30 as a tax refund. 

With no tax to pay, the retiree will have the full $100 to spend. 

How franking credits can boost your return in retirement

As the above example demonstrates, retirees are in a unique position. Most are likely to have a 0% tax rate and receive the franking credits that their portfolio generates as a tax refund. 

Let’s see what this looks like in reality, considering what might happen for a portfolio of $1 million invested 30% in cash, 30% in global shares and 40% in Australian shares. 

As you can see from the table below, an investor could potentially earn $40,000 of income a year in retirement from this portfolio. When the value of franking credits is included in this calculation, income is increased by 12% to $44,800. 

An extra $4,800 a year from franking credits, in a well-diversified portfolio, is a significant sum of money and shows the contribution that franking credits can make to retirement income. 
 

Franking credits in retirement

*Assumes 5%p.a. cash interest, 3%p.a. global share income and 4%p.a. Australian share dividends. **Based on an average franking rate of 70% on the Australian share income. This assumes a mix of fully franked, partly franked and unfranked dividends are received. 

Key takeaways

Franking credits are a unique element of the income paid to investors who own Australian shares. They help offset tax paid during a working lifetime and, in retirement, can add significantly to the income received from Australian share investments.