This article appeared in the May 2014 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
How franking credits help SMSFs.
By Nerida Cole, Dixon Advisory
With three of the big four banks having recently paid dividends and tax time around the corner, it is a good time to consider the benefits of franking credits. Self-managed super funds (SMSFs) are in a unique position to use these credits to their advantage, even more so if they are in pension phase.
This article explains how to get the most out of franking credits for your SMSF and where fully franked, dividend-paying shares fit in a diversified portfolio.
SMSF investors receive distribution of profits from the Australian companies they invest in in the form of dividends. Understanding the true value of these payments can be more complicated than initial appearances indicate, because both the cash component and the tax credit or adjustment need to be considered in calculating the net yield - yet both components are received at separate times.
The cash component of the dividend is paid to the shareholder throughout the year after covering the company tax rate of 30 per cent. The amount of tax paid is recorded as a franking, or imputation, credit and through the tax return system the final tax liability of the shareholder will take into consideration this franking credit.
Tax-savvy investors appreciate that the potential to receive a refund of the franking credits will boost the overall income their fund has received, thereby making the most productive use of their capital and increasing the overall return of their portfolio. The end result is that they have increased the pool of money they can use to fund their retirement.
Franking credits favour lower marginal tax rates
SMSFs have a tax rate lower than the company tax rate and this allows SMSFs that invest in Australian companies to receive a part or full refund of franking credits in addition to the cash component of the dividend. This sweetener in the form of additional income and funds for investing can be lost if inefficient tax structures are used.
If you look at an SMSF that had invested $500,000 equally across the big four banks on 31 March 2013, the cash dividends received by the SMSF over the following calendar year would have been $29,810, representing a yield of 5.96 per cent.
As SMSFs in full pension phase have a tax rate of zero, the SMSF would have generally been entitled to a full refund of the franking credit of approximately $12,775. This increases the value of the dividend by 42 per cent to $42,585.
SMSFs that had not yet reached pension stage would still have been expected to receive a partial refund of franking credits, as the SMSF accumulation phase tax rate of 15 per cent is still substantially lower than the company tax rate.
SMSF has superior tax structuring
Individuals and other entities also benefit from the franking credit system, but it is hard for many entities to compete with the superior tax structuring of an SMSF. If you hold shares personally, you will pay tax on the dividends at your marginal tax rate and the franking credits will be used to reduce the amount of overall tax you must pay. But if your individual tax rate is not lower than the company tax rate, it is unlikely you will receive a refund of the franking credits.
Individuals with a 32.5 per cent marginal tax rate might believe they do not pay any tax on dividends, but this is not correct. It is simply that the company has already paid the tax at 30% and the ATO uses this franking credit to offset the individual's personal tax liability. If the same individual was able to own their shares in a zero per cent tax structure, such as an SMSF pension account, they would receive a full refund of the tax.
Referring to the earlier example discussed above, the individual holding the same $500,000 share portfolio receives $12,775 less each year due to tax lost.
Investors approaching retirement or in a strong financial position may consider moving some of their holdings into the lower tax environment of an SMSF. These types of transfers can be made in specie to the SMSF, but as they are still subject to capital gains and contribution limit restrictions, investors will need to tread carefully and obtain assistance from their accountant and adviser.
Maximising the benefits in the SMSF
While the refund of franking credits as part of the tax return provides a cash injection that can help if portfolio liquidity is tight, experienced advisers will have already factored this into the overall management of the self-managed super fund's portfolio. The adviser will balance the income received, including the franking credit refund, against the expected pension payments, reserve requirements and expenses, so that liquid cash can be well managed.
This means your SMSF is able to maximise the amount of capital it has available for taking advantage of market opportunities.
SMSF trustees must keep in mind that the refund of franking credits only occurs when the SMSF lodges its tax return. Consequently, the earlier a fund's tax return is lodged, the earlier the benefit of the franking credits is realised. A key consideration when choosing a service provider that will complete your fund's return is how quickly they can get their work done and lodge your SMSF's return after the end of the financial year.
Balance is the key
Although the benefits of franking credits are particularly attractive, investors should continue to approach investment in Australian shares as part of a properly diversified portfolio to reduce over exposing themselves to other risks.
Australian shares are growth assets and will be affected by high levels of volatility and the risk of capital loss. Even when dividend income is taken into account, on average the All Ordinaries index would be expected to produce a negative annual return four or five times over a 20-year period.
Although some Australian companies try to aim for some stability in dividends to attract investors, dividend payments are not guaranteed and can fluctuate. In a downturn, where an investor could lose capital and the income stream from those payments, it is important to have considered what other investments might work in a counter-cyclical method.
Accordingly, high-yielding Australian shares should be held as one part of a diversified portfolio that spans a number of asset classes. An experienced investment adviser will be able to help you consider the risks and how they apply to your individual situation.
Franking credits from Australian shares provide an extra return above the cash dividend payment, allowing investors, particularly SMSF trustees, to maximise the return on their portfolio. However, investing in shares purely for the franking credits will increase the volatility and risk in the portfolio and as with any investment, should be considered as part of a balanced portfolio that is suitable for your individual circumstances, goals and tolerance for risk.
About the author
Nerida Cole is Managing Director, Financial Advisory, Dixon Advisory.
The ASX Find a broker tool helps you select the products, services and types of investments you are looking to get from a broker. It explains the difference between full-service and non-advisory brokers, outlines important considerations before you start trading, and the questions to ask your broker. It can help you choose the right adviser and develop a productive relationship.
© Copyright 2017 ASX Limited ABN 98 008 624 691. All rights reserved 2017.