Unlocking the power of franked dividends for wealth and income growth

If there is one important financial principle that is widely misunderstood or simply ignored, it is the importance of fully franked dividends.

I would argue that franked dividends are one of the absolute keys to building wealth over time and producing a growing and tax effective income stream but that point is rarely mentioned or fully appreciated.

To give an example, when the new tax scales come into operation from July 1, it will be possible for anyone earning $135,000 a year or less to receive tax free dividend income.

That is because the franking credits attaching to dividends will exactly match the company tax paid by the company issuing the dividends.

Benefits right across the income scale

Those on lower tax scales will be able to claim a tax refund for the excess franking credits they earned and those fortunate enough not to pay tax – such as retirees – will be able to claim a full tax refund for all of their franking credits.

Even those fortunate few who earn above $135,000 and who may still be salty because Treasurer Jim Chalmers backed down on the size of their expected tax cut, will be able to receive their fully franked dividends largely tax paid, only needing to top up the company tax rate to their personal tax rate.

Dividends part of why we should all keep buying shares

One of the most proven financial planning ideas is to keep increasing the percentage of your assets invested in shares even well into retirement, with franked dividends one of the important reasons for adopting that strategy.

Apart from the financial planning benefits of franked dividends, there are important structural reasons why they are such a good idea.

Giving companies strong incentives to pay tax

The attractiveness of fully franking dividends is an important advantage for Australian companies and it is therefore a strong incentive for particularly larger and more mature companies to pay their company tax so they can fully frank their dividend payments.

This makes their shares much more attractive to Australian investors and also helps to keep the amount of company tax collected stronger than it might otherwise be.

Looking at it from the other direction, Australians who are paid franked dividends have a strong incentive to fill out their tax returns annually and on time so that they can access their franking credits.

This is particularly the case for retirees, who might otherwise be inclined to give up doing tax returns if their income is largely tax free out of a super fund.

Franked dividends cost Bill Shorten his shot at Prime Minister

While it is still controversial that some retirees receive a tax refund for their franking credits, the fact is that a policy to eradicate that refund system played a big part in Bill Shorten failing to win government in 2019 shows that everyday voters like the franking credit system, which is virtually uniquely Australian.

The idea of having franking credits is to avoid the double taxation of dividends which used to occur before franked dividends were introduced.

The reason why franked dividends are so powerful for people on all of the income tax scales is that they are unusual in that they mean recipients are getting income that is fully or largely tax paid and in the case of retirees is able to be “grossed up” for a tax refund.

That is certainly not the case for bank interest and most other investments, which must be declared on tax returns and then have tax paid at the taxpayer’s full marginal rate.

Franking leads to compounding returns

That points to one of the key advantages of franked dividend income, in that it allows for further compounding of returns over time compared to cash in the bank because you get to keep more of your return after tax and can also plough it back into the share market by buying more shares or by taking part in dividend reinvestment programs.

Over time, the building up of a franked dividend income stream can be very important in helping people on all levels of income increasing their wealth and income self-reliance.

Quite simply, franked dividends compare extremely favourably to most other forms of income and particularly interest income, due to tax and compounding advantages.