One of the key advantages of Self-Managed Super Funds (SMSFs) that is often overlooked is the significance of franking credits linked to dividends from top-tier shares. Through strategic portfolio adjustments, you can maximize the tax advantages for your fund.
It's not very challenging to focus on imputation credits, which mainly come from investing directly in Australian companies and, to a lesser degree, through managed funds. Imputation credits, also called franking credits, can be used to reduce the tax owed on the fund's taxable income during the accumulation phase. In the pension phase, you may even be eligible to receive refunds from the ATO. Who wouldn't appreciate getting money back from the ATO?
Understanding Franking Credits
It is important to note that franking credits are beneficial because super funds are taxed at a low rate of 15% during the accumulation phase and pay no tax during the pension phase. Fully franked dividends can result in imputation credits of up to 30% of the gross dividend from an Australian share. This implies that the franking credit offsets the tax owed on the dividend and provides a substantial surplus to offset other tax liabilities of the fund or to request a refund.
How It Works
Let's illustrate this with an example. Let's say WE Pty Ltd earns a $1.00 profit and is subject to a 30% company tax on this profit. The company pays $0.30 (30% of $1) in cash to the tax office and records this amount in their franking account. The franking account serves as a ledger of payments made, without containing physical money. The company's ability to frank its dividend is determined by the balance in this franking account. If there is a surplus, the company can declare a fully franked (100% franked) dividend. Otherwise, the company may declare a partially franked dividend.
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The dividend received by the SMSF is "grossed up" by the amount of the imputation credit to achieve a grossed-up dividend. Tax is then assessed at 15% or 0%, depending on the phase of your SMSF. The fund is then entitled to a tax offset for the franking credit.
Example
Here's a worked example of an SMSF that only holds CBA shares and BHP shares:
Dividend | Franking Credits | Taxable Income Accumulation Phase | Taxable Income Pension Phase | |
CBA Shares | $1640 | $700 | $2,340 | $2,340 |
BHP Shares | $1280 | $550 | $1,830 | $1,830 |
Total | $2920 | $1250 | $4,170 | $4,170 |
Tax @ 15% |
|
| $625.50 |
|
Tax @ 0% |
|
|
| $0 |
Less: Franking credits |
|
| $1250 | $1250 |
Excess Franking credits |
|
| $624.50 | $1250 |
In this example, not only will the fund pay no tax on the dividend income of these two shareholdings, but it will have:
Accumulation Phase: $624.50 of excess franking credits
Pension Phase: $1250 of excess franking credits
The SMSF Trustees can use these excess franking credits to offset other tax liabilities of the fund (such as other income, capital gains, and taxable contributions). If no other liabilities exist, the SMSF fund can receive a refund of this amount. Isn't that fantastic?
Simplified Formulas
To make it easier, here are the simplified formulas used in the calculations:
Grossed-Up Dividend: [ \text{Grossed-Up Dividend} = \text{Dividend} + \text{Franking Credit} ]
Tax Payable in Accumulation Phase: [ \text{Tax Payable} = \text{Grossed-Up Dividend} \times 0.15 ]
Excess Franking Credits: [ \text{Excess Franking Credits} = \text{Franking Credit} - \text{Tax Payable} ]
The 45-Day Rule
Fully franked dividends and franking credits make investing in Australian shares a very tax-effective strategy. However, to prevent investors from abusing the system (called dividend stripping), the ATO introduced the 45-day rule. This rule states that shareholders must hold shares for 45 days (not counting days of purchase or sale) for any franking credits over $5,000.
Beware of Blind Dividend Chasing
A word of caution before you decide to invest heavily in shares with the highest dividends: while high-yielding dividend stocks may look enticing, they can be useless if those shares drop in value. Always research the company and look for strong fundamentals. For example, what does the company’s dividend history look like? Are the dividends growing year on year in line with the earnings per share? Is there long-term potential for this company? Will earnings rise in the near term, and are they sustainable?
If you're looking for a superannuation review or an adviser who will keep you updated and provide guidance and tips like in this blog, feel free to reach out! Franking credits can be a game-changer for your SMSF, and it's worth celebrating their benefits! 🎉
Feel free to ask if you have any more questions or need further assistance. Alternatively, click the link to swiftly discover how this strategy can enhance your portfolio.
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