Explainer: dividend income and franking credits

Never heard of franked dividends? Not sure how they work? This explainer will help you understand how franking credits affect the amount of tax you pay.

If you’re an investor in the Australian stock market, it can be helpful to understand how dividends and franking credits work. But where do you start? Read on to get a grip on the basics.

How dividends are taxed

Dividends represent the return companies pay shareholders on their share investments, generally out of their profits. The reason you need to keep track of them is because in Australia, dividend income is considered part of your assessable income and needs to be declared on your tax return. How much tax you pay on your dividends depends on your marginal tax rate – see example below.

In Australia, we have a dividend imputation system in place. Here’s the part where franking credits come in – they may provide you with a tax offset.

Please explain: Franked vs unfranked dividends

You can pick from ten themed ETFs with CommSec Pocket including:

•  Franked dividends: When a company pays shareholders dividends from money they’ve already paid tax on. These franked dividends come with franking credits which means you get tax credits on the taxes already paid at the corporate level.

•  Unfranked dividends: Generally, when a company hasn’t paid tax on profits before distributing them as dividends. As a result, you’ll pay tax on the full amount of the dividend at your marginal tax rate.

How franking credits actually work

Franking credits are like tax offsets or credits that come with your dividends. They help reduce the tax you owe on your dividend income and the ATO might refund you in cash where your tax liability is less than your franking credits.

Here's how it works: suppose you get a $1,400 dividend with a $600 franking credit. This means the company has already paid $600 in tax on that dividend. When you complete your tax return, you report both the $1,400 dividend and the $600 franking credit, resulting in $2,000 of assessable income.

Now, let’s assume that:

•  You did not claim any other allowable deductions

•  Your marginal tax rate is 37% (factoring in other income sources, e.g. salary income)

Normally, you’d expect to owe $740 in tax on that $2,000. However, thanks to the $600 franking credit, you could be eligible to offset the $740 tax with the $600 franking credit, so your tax liability is $140. So, franking credits could potentially offset the amount of tax you have to pay.

Other things to consider about franking credits

Understand the holding period rule:

To get franking credits, you must generally hold the shares for at least 45 days (90 days for preference shares). This rule stops people from short-term trading just to get the franking credits attached to the dividends.

Attention low-income earners:

If your income tax rate is below the corporate tax rate, you might be eligible for a refund of any excess franking credits.

Disclaimer

Taxation considerations are general and based on present taxation laws and may be subject to change, they do not take into account your individual objectives, financial situation or needs. You should seek independent, professional tax advice before making any decision based on this information.

Commonwealth Securities Limited (CommSec) is also not a registered tax (financial) adviser under the Tax Agent Services Act 2009 (Cth) and you should seek tax advice from a registered tax agent or a registered tax (financial) adviser if you intend to rely on this information to satisfy the liabilities or obligations or claim entitlements that arise, or could arise, under a taxation law.

For the latest information, check the ATO website or speak to your accountant or financial advisor.