For many self-funded retirees and those relying on a fixed income from investments, the persistent low interest environment continues to restrict their income and lifestyle. Understandably, many investors lean towards fixed income investments where their capital is protected, but this leaves them boxed in when it comes to earning a decent income to live on.
So what options are there?
The relentlessly low interest returns have pushed some investors to look further afield to diversify their investments as a way of seeking greater yields. Growth assets such as equities can offer alternatives, although this presents greater risks in capital security.
Once a thorough analysis of risk appetite has been made, some fixed interest ‘die-hards’ may feel that spreading their investments to include a modest proportion of shares in their portfolio may be a worthwhile course of action in the search for greater income.
If you do decide to diversify into growth investments, such as equities, it is important to ensure that you look for ways to maximise returns to help balance the higher capital risks. One of the major ways this objective can be achieved is by taking advantage of a tax saving device known as franking credits, which are available on investments made in Australian equities.
How it works
The franking credit system (also known as imputation credits) dates back to 1987 when the federal government sought to relieve investors of the inequity of effectively being taxed twice on investment income from company dividends. Prior to this change, companies listed on the stock exchange paid tax on their income before declaring a dividend to those who were investing in that company’s shares. The investor was then paying their marginal income tax on the dividend income they were receiving.
Franked dividends alleviated this double taxing by allowing the investor to claim a tax rebate to compensate the investor for the company tax that had already been paid by the company. For example, if the investor was currently paying a top marginal tax rate of 37 per cent on their dividend income, they were allowed to claim a tax rebate equivalent to the 30 per cent company tax rate that had already been paid by the company before it declared the dividend.
The scenario for investors who are only on the 30 per cent tax rate or lower is even better. If you are paying tax at 30 per cent the franking credit may effectively cancel out all the tax payable from the dividend income. If your tax rate is lower than 30 per cent you may even achieve a tax refund, based on the difference between the 30 per cent franking credit and your marginal tax rate.
Managed funds may pay franking credits too
You don’t necessarily need to invest in shares directly to gain the benefit of franking credits. If a managed fund is investing in domestic shares then they may well be able to pass on franking credits when they make income distributions to investors. The fund will normally inform you of the amount of such franking credits on the annual tax statement they send you. You then simply pass this on to your accountant or tax agent to make sure you receive the tax benefit of the franking credit when they submit your tax return.
Advice is key
If the low interest environment is constraining your income, perhaps diversifying to seek a greater income stream in the form of franked dividends is something you should consider. While there are obvious attractions in this system, it is vital that you receive your own tax advice on whether it is relevant for your situation. The inherent risks in making equity investments must also be taken into consideration, so it is important to seek advice from a qualified financial planner to help you make a balanced decision on whether such risks are appropriate for your circumstances.
Have you taken advantage of franked dividends from equity investments? Share your thoughts below.