Franked vs. Unfranked Dividends: What’s the Difference?

There has been a never-ending debate surrounding franked vs unfranked dividends. It has been a discussion among accountants, tax specialists, and financial advisers for years. Since Australia introduced the imputation credit system over 40 years ago, experts have agreed to disagree on this debate. While franked dividends have tax benefits, unfranked dividends help investors diversify their portfolios. The latter is beneficial for international investments. Knowing the differences between these two dividend forms enables you to make your investment decision.

This article will explore the difference between franked and unfranked dividends. We’ll examine each’s tax implications and discuss how they fit into a broader investment strategy.

What Are Franked Dividends?

Let’s not jump the gun. The first question should be, what are dividends?

Dividends are a part of a company’s profits paid to its shareholders as their share. The board of directors decides the amount based on the company’s latest earnings. Dividends are paid either in cash or extra shares.

Companies distribute earnings back to investors as a return on investment in different ways. Some pay these dividends after paying taxes, while others pay them before they submit the taxes. That’s why dividends are classified as either franked or unfranked.

With that, we can now go ahead and define franked dividends.

Franked dividends are dividends a company distributes to shareholders after paying tax on the profits.

In Australia, the standard corporate tax rate is typically 30%. Once the company has paid this tax, its shareholders should not pay tax on their dividend income. Otherwise, it would be double taxation.

So, the company passes on a franking credit to the shareholder. These franking credits prove that the company has already fulfilled its tax obligations on these dividends.

For example, imagine you receive a fully franked dividend of $700, which includes a franking credit of $300. This means that the total pre-tax dividend was $1000. With a 20% tax rate, you owe $200 in tax on $1000, but with a $300 franking credit, you don’t pay anything. In fact, you receive a $100 refund. With a 45% tax rate, you owe $450 in tax on $1000, but with a $300 franking credit, you only pay $150.

How Franked Dividends Affect Your Tax Obligations

As a shareholder, when you receive a franked dividend, you also get an attached franking credit. The credit is for you to offset your tax liability. This tax credit either reduces the income tax you owe or could even result in a tax refund.

This system aims to make dividend income more tax-efficient. It ensures that the same profit isn’t taxed twice. Once the company pays it at the corporate level, you don’t do it again at the personal level. After all, what’s a company? It is a legal entity representing an association of legal people we call shareholders. So, as a shareholder, once your company has paid corporate tax on profits, the franked dividends you receive are tax-free.

If you’re in a lower tax bracket than the corporate tax rate, you could enjoy a refund when filing your tax return. Let’s say you receive a franked dividend of AUD 100 from a company already paying 30% tax on the distributed profit. If your personal income tax rate is 15%, the franking credit can be applied to reduce or drop your tax liability. It potentially entitles you to a refund of the overpaid tax.

Advantages of Franked Dividends

• The franking credits ensure that, as a shareholder, you aren’t taxed twice on the same profit.
• They significantly reduce your tax burden. You may even receive refunds if you are in a lower tax bracket.
• They are attractive for retirement savings. Due to their tax efficiency, franked dividends are a popular choice for superannuation funds.

What Are Unfranked Dividends?

Unfranked dividends are the opposite of franked dividends. Companies pay dividends on profit before tax, so distributed profits must be taxed.

Unfranked dividends are profit shares distributed to investors before the company has paid tax on them. Because they do not come with franking credits, shareholders must pay tax on the total dividend amount at their marginal tax rate.

Without tax credits, these dividends can lead to a higher tax bill than franked dividends. For example, if you receive an unfranked dividend of $700, with a 20% tax rate, you’d owe $140 in tax, but with a 45% tax rate, you’d owe $315 in tax.

Why Do Companies Pay Unfranked Dividends?

There are several reasons a company may distribute unfranked dividends:

• The company may have made no taxable profits in the current financial year.
• It might be carrying forward losses from previous years.
• The company may be located outside of Australia and thus not subject to Australian corporate tax.

International companies listed on the Australian Stock Exchange (ASX) are not liable for Australian tax. So, they don’t pay taxes in the country and can’t offer franked credits. They often distribute unfranked dividends, which doesn’t necessarily make them a bad investment.

Advantages of Unfranked Dividends

• Global Exposure. International companies often pay unfranked dividends. These international investments allow you to diversify your portfolio across markets.
• Potential for long-term gains. Companies that pay unfranked dividends may still have strong growth potential. This is especially true if they are well-established or expanding globally.

Key Differences Between Franked and Unfranked Dividends

The difference between franked and unfranked dividends is tax treatment and portfolio strategy. Each type of dividend has distinct implications for your taxable income. And overall, they influence your investment performance.

1. Tax Treatment

For Franked Dividends, they come with franking credits, which reduces your tax liability. So, as a shareholder, you pay less tax or receive a refund if your tax liability is lower than the franking credit.

On the other hand, Unfranked Dividends do not come with franking credits. Thus, you must pay the total tax on the dividend income based on your tax rate. This could sometimes lead to a higher tax burden.

2. Corporate Tax Paid

The company has already paid corporate tax on the profits being distributed as Franked Dividends. So, it passes the franking credit, which benefits you as the shareholder.

The company has not paid corporate tax on the distributed profits for Unfranked Dividends. So you don’t claim any franked credits, meaning you bear the entire tax burden.

3. Portfolio Considerations

Franked Dividends are from Australian companies that generate taxable profits within the country. Therefore, such companies make a good option for investors seeking tax-efficient income.

Meanwhile, Unfranked Dividends are typically from international companies or companies with tax-exempt income. Though they come with higher tax obligations, the companies help you diversify your portfolio.

4. Impact on Net Cash Flow

Through Franked Dividends and thanks to franking credits, you may keep more of your dividend income after taxes. With more cash, you have an improved net cash flow.

But with Unfranked Dividends, you don’t get the tax credits. So, you will pay more tax on your dividend income, potentially reducing the overall net cash flow from the investment.

Impact on Investment Strategy

There’s no clear-cut answer. The debate between franked and unfranked dividends rages on for good reasons. Ultimately, the choice depends on your personal financial situation. And this includes your tax obligations and investment goals. For the best decision, consider the following:

Conclusion

The main difference between franked and unfranked dividends lies in their tax treatment. The former has the issuing company paying the taxes, so they come with tax credits. The former include taxes but don’t have these credits.

Choosing between franked and unfranked dividends depends on your situation and investment goals. Franked dividends offer tax benefits through franking credits. Indeed, they are a smart choice for investors aiming to reduce their taxes or boost after-tax returns. On the other hand, unfranked dividends equally add value by diversifying your portfolio. Though they lack tax credits, they can still also give access to international companies with strong growth potential.

From an expert point of view, a mix of both types offers the best approach. The balance combines the tax advantages of franked dividends with the growth opportunities of unfranked ones. If you feel overwhelmed by the decision, you can always consult a financial adviser. They can help you create a strategy that suits your financial needs and builds long-term wealth efficiently. You can also read and learn from us at BrokerRaters.com for more financial tips and expert advice. We always have something new to share.