The Wonders Of Franking Credits

One of the most underappreciated aspects of investing on the share market is the effectiveness of franked dividends in growing wealth.

As billions of dollars of franked dividends are progressively being paid into shareholder’s accounts at the moment, it is worth remembering what is so great about Australia’s system of franking credits.

Because tax on the dividend has already been paid at the company tax rate of 30%, in the hand of the investor that franking credit belongs to them.

Even if the investor is on the top marginal tax rate of 47%, that often means they only have a small amount of extra tax to pay if it is added to their personal exertion income.

For those on lower income tax rates, there is often no further tax to be paid and credits to be claimed and if franked dividends are held within superannuation the benefits are even greater.

Franked dividends Particularly Great in Super

Superannuation funds are only taxed at 15% within accrual mode superannuation accounts and are tax free in retirement.

So franking credits are extremely useful in reducing any super tax and as acting as a genuine “grossed up” extra yield.

What that means is that half of the franking credit remains for a super fund in accrual mode but the entire franking credit applies when the super fund is supporting someone in retirement.

Always Look at the Underlying Fundamentals

It is important not to just look at the tax implications when making any investment.

You must also look at the company, fund or ETF involved closely to ensure the underlying investment is sound and growing.

There is also a bit of a two-fold concentration risk in trying too hard to pursue franked dividends – you can end up with a concentration of large, mature Australian company shares and secondly, a concentration on large banks and other financial shares.

Just seven companies paid more than half of the total dividend payments in Australia – the big four banks CBA, NAB, ANZ and Westpac plus BHP, Fortescue and Woodside Energy.

Dividends to Look For

Of course, it is possible to construct a good fully franked dividend supply outside those seven stocks but what should you be looking for?

One of the characteristics is a dividend stream that is not just fully franked but one that is growing over time due to growing underlying earnings.

One great example is Washington H Soul Pattinson (ASX: SOL), which has increased its dividend every year since 2000 and has paid dividends every year since it was formed in 1903.

That’s about as close as you can get to dividend royalty in Australia and Soul Patts has achieved those results through a fairly simple mantra to try to boost the growth of its capital as measured by net asset values and to have enough cash generation within its portfolio to pay steady and growing dividends.

A Great Formula to Follow

That’s not a bad formula to follow for any investor with the pursuit of capital growth being the overarching goal and the growing dividends coming in as an important secondary goal.

As well as well managed listed investment companies such as Sol Patts, Australian Foundation (ASX: AFI)and Argo Investments (ASX: ARG), there are several exchange traded funds that are designed specifically to produce high franked dividends.

These include Russell High Dividend Australian Shares ETF (RDV), SPDR MSCI Australia Select High Dividend Yield Fund (SYI) and Vanguard Australian Shares High Yield ETF (VHY) to name just a few.

Chosen carefully, a good dividend portfolio can provide a rising dividend income over time until the dividend yield and franked income on the original investment is impressive indeed.

Just Buying for Yield Can Be a Disaster

Without the right care though, shooting just for dividends can be disastrous with some high yielding shares effectively ex-growth and sometimes even on their last legs.

A high dividend yield may not be sustainable and might even be a sign that a company’s underlying earnings are declining.

When looking at shares, you should assess the total return over time – that is the share price performance and the yield.

If both are rising, that is likely to indicate a company with better prospects than one where either is falling.