The definitive SMSF guide to franked dividends

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What are franking credits?
How it works
What dividend yields are on offer?
The 45-day rule
Retirement income strategy
The hunt for yield

Many Australian listed companies, the banks, miners and Telstra in particular, are known for paying reliable dividend income, with an average dividend yield of just over 4% over the past 40 years.

But dividend yields are even more attractive when franking credits are included, especially for SMSF investors in retirement phase. But before we get to that, let’s brush up on franking.

What are franking credits?

Franking credits represent tax a company has already paid in Australia on any profits it distributes to shareholders by way of dividends. The company tax rate in Australia is currently 30%, or 27.5% for companies with turnover of less than $25 million.

Shareholders can then use these franking credits, also known as imputation credits, to offset their tax liability on other income, including salary, at the end of the financial year. People who pay no tax, notably SMSF investors in retirement phase, can claim a full tax refund from the ATO.

Good to know

Our system of dividend franking, or dividend imputation, was introduced to prevent the double taxation of company profits. Dividend imputation is so called because the tax a company has paid on its earnings is ‘imputed’ (taken into account) when profits are distributed to shareholders as dividends.

Because companies are not obliged to pay tax on profits before distributing them to shareholders, dividend payments can be fully franked, partially franked or unfranked. The franking amount is reported as a percentage, for example, a 70% partly franked dividend means the company has paid tax at the full 30% company rate on 70% of the dividend but not the remaining 30% of the dividend.

If your marginal tax rate is less than the company tax rate of 30%, you would be eligible to receive a refund of the difference between the franking credit and your tax payable.

That is why SMSFs are so attracted to shares in Australian companies that pay fully franked dividends. Super funds pay a top income tax rate of 15% and no tax on the earnings or income of investments supporting a retirement pension. So refundable franking credits can boost the income yield of an investment substantially.

Here’s how.

How it works

Franking credits have different impacts depending on your marginal tax rate and whether your share investments are held inside or outside super.

Case study

Marta owns shares in a company that pays her a fully franked dividend of $700. Her dividend statement says there is a franking credit of $300, which represents tax the company has already paid. This means the dividend before company tax was deducted would have been $1,000 ($700 + $300).

In her annual tax return, Marta must declare the full $1,000 ($700 dividend plus $300 franking credit) in her taxable income. The after-tax value of the dividend will then depend on her marginal tax rate.

The table below shows the outcome for four scenarios, depending whether Marta holds the shares in her SMSF in retirement phase (0% tax) or accumulation phase (15% tax); or outside super in her own name. (We have included calculations for the two top income tax brackets of 32.5% and 45%, but if Marta is a low-income earner on a tax rate of less than 30% she may receive a cash refund).

	SMSF pension	SMSF accumulation	Own name tax	Own name tax
Dividends paid	$700	$700	$700	$700
Franking credits	$300	$300	$300	$300
Taxable income	$1,000	$1,000	$1,000	$1,000
Marginal tax rate	0%	15%	32.5%	45%
Gross tax payable	$0	$150	$325	$450
Tax payable (refund)	($300)	($150)	$25	$150

As you can see above, if Marta is retired and holds her shares in her SMSF pension account, she will receive a total dividend payment of $1,000 ($700 dividend and a cash refund of the attached franking credits).

If she’s not retired but holds her shares in her SMSF, she still receives $850 ($700 dividend and $150 cash refund of franking credits). If she holds the same shares outside super, there will be some tax to pay on her dividend income.

It’s no wonder retirees and people with their own SMSF have been flocking to shares with high dividend yields. Not only are dividend yields higher than you can earn by putting your money in the bank, but they offer potential tax benefits.

What dividend yields are on offer?

For decades now, popular stocks such as the big four banks, Telstra and the mining giants have provided grossed up dividend yields (including franking) in the range of 4% to 8%. When capital appreciation is taken into account, Australian shares have provided long-term wealth creation.

However, due to the impact of COVID, many companies cut or paused dividend payments, and this reduced the overall market dividend yield from the historic average of just over 4% to 2.6% by April 2021.

The dividend yields of the banks were particularly hard hit because of their exposure to the economic downturn that followed, but also because their share prices soared as the market recovered.

While the banks have slipped out of the top dividend yielding stocks, there is still plenty on offer.

Important to note

The dividend yield on a share is measured by dividing the current share price by the past 12 months’ dividend payments.

So in some cases a high dividend yield can result when a company’s share price falls due to poor performance. Conversely, a sharp rise in a company’s share price will lower the dividend yield. For this reason, it’s important not to buy shares for the dividend yield alone until you have taken the company’s overall financial health and future prospects into account.

The table below shows some of the top dividend yields on the ASX in May 2021, the grossed-up yield (including franking) and the franking percentage. This is not a recommendation for any of the companies listed; simply an illustration of the yields available.

As you can see, franking can add 3% or more to the yield.

Company	Dividend yield	Gross dividend yield	Franking
Fortescue Metals Group	11.5%	16.4%	100%
Harvey Norman	8.2%	11.7%	100%
Aurizon Holdings	7.9%	10.2%	70%
Cromwell Property Group	7.6%	7.6%	0%
Rio Tinto	6.1%	8.8%	100%
JB Hi-Fi	5.6%	8.0%	100%
IOOF Holdings	6.1%	7.3%	100%
Platinum Asset Management	4.9%	7.1%	100%
Magellan Financial Group	4.7%	6.2%	75%
Telstra	4.6%	6.6%	100%

Source: Various, at 26 May 2021.

The 45-day rule

A high, fully franked dividend is a powerful attraction for anyone seeking to maximise the income from their investments. But you can’t just buy a stock for its dividend one day and sell the next. There are rules.

To be eligible for franking credits you must:

Hold your shares for a minimum of 45 days, excluding the days of purchase and sale
Purchase the shares before the ex-dividend date
Be holding the shares on the ex-dividend date, although you can sell on this date.

Need to know

The ex-dividend date is the first day a stock trades without the value of the next dividend payment. This is typically one business day before the record date, meaning that an investor who buys the stock on its ex-dividend date or later will not be eligible to receive the declared dividend. You can find the ex-dividend and record dates for a stock on the company’s website.

The 45-day rule doesn’t apply if you are an individual taxpayer and the total franking credits being claimed are less than $5,000 for the financial year.

Retirement income strategy

Most of Australia’s top companies have emerged from the pandemic in fundamentally good shape and continue to offer attractive dividends enhanced by franking credits.

For more on the dividend outlook, see SuperGuide article Dividends shaken but not stirred.

Even so, choosing shares based purely on dividends or tax benefits rather than looking at the fundamental value and future growth prospects of the investment is a dangerous game and could put your capital at risk.

Temporary cuts and suspension of some dividends during the pandemic also highlight the risks of relying too heavily on one investment strategy. All investors, whether in accumulation or retirement phase, need to diversify their income sources to reduce market, regulatory and other risks.

Despite low interest rates, it is still important to have cash at hand to cover your spending requirements in the short to medium term and to avoid liquidity issues with other investments.

Bonds and other fixed income investments traditionally offer regular income and there are signs that long-term bond yields are slowly beginning to lift from historic lows.

Residential investment property also provides reliable income. According to CoreData, the national average gross rental yield was 3.5% in April 2021.

The hunt for yield

Not all companies take the same approach to dividends, with some historically distributing more cash to shareholders than others. When assessing a company’s dividends and franking policy, it’s a case of looking for quality not quantity.

When companies earn a profit, they must decide how much to pay shareholders in dividends and how much to plough back into the company to fuel growth. So a company with strong growth prospects may pay a relatively low dividend. At the end of the day, it’s the total return on your investment that counts, from a combination of long-term capital growth and the dividend income you receive along the way.

That said, franked dividends are popular for good reason and finding out who pays what has never been easier.

A simple Google search can give you information on a company’s dividend and franking policies, or you can go to their website.

Financial advisers and brokers should be able to provide you recommended lists of high yielding stocks with good fundamentals.

You can also find the information for yourself via online broker sites or free sites such as marketindex.com.au, which regularly updates its list of ASX top dividend yields.

Happy hunting!