Why invest in shares that pay franked dividends?

Key takeaways

• The key benefits of franked dividends, including tax efficiency, and a stable income stream.

• How franked dividends can act as an effective hedge against inflation.

As a savvy investor, you should always be on the lookout for strategies that not only promise financial growth but also provide a consistent stream of income. One such avenue is shares that pay franked dividends.

In this article, we delve into the compelling reasons why these dividend-paying shares have become a focal point for investors seeking a balanced and rewarding investment portfolio, and how you can take advantage of them. 

Understanding franked dividends

Before we outline the benefits of investing in shares with franked dividends, let’s clarify what franking means.

In Australia, the imputation system aims to avoid the double taxation of company profits. The imputation system refers to the tax treatment of dividends paid by Australian companies to their shareholders.

When a company earns profits, the profits are subject to tax. The company can then distribute these earnings to shareholders as a dividend. The company can choose to pay tax on some, all or none of the dividends paid. If the company does pay tax on the dividend, you’ll receive ‘franking credits’ when the dividends are paid to you. The franking credits recognise that tax has already been paid on the amount, and ensure there’s no double taxation if this income. As a shareholder, the franking credits are refunded to you when you do your tax return and offset your own tax liabilities, resulting in a more tax-efficient investment. In some circumstances you may receive a refund.

Key benefits

There are numerous benefits associated with investment in shares that pay franked dividends. Key amongst those are:

• Stable income streams – Ideal if you’re seeking stability in your investment portfolio, especially when it comes to generating a reliable income stream. Shares that consistently pay franked dividends are known for their stability, as companies that prioritise dividend payments typically have robust financial health. These dividends act as a regular income stream, making them an attractive option if you’re an income-focused investor looking to supplement your cash flow.

• Signal of financial health – Companies that consistently pay franked dividends are generally viewed as financially stable and well-managed. A track record of dividend payments signals a company’s confidence in its future earnings and cash flow. Investors often interpret a history of franked dividend payments as a positive indicator, suggesting that the company is capable of generating consistent profits and has a commitment to rewarding its shareholders.

• Tax efficiency – One of the primary advantages of investing in shares with franked dividends is tax efficiency. Imputation credits serve as a shield against double taxation, providing you with a significant advantage. When you receive franked dividends, you are entitled to claim the imputation credits attached to those dividends, reducing your overall tax liability. This tax efficiency can translate into higher after-tax returns compared to other investment options.

• Long-term wealth accumulation – Investing in shares with franked dividends aligns well with a long-term wealth accumulation strategy. The compounding effect of reinvesting dividends can significantly boost your overall return on investment over time. By reinvesting both the cash dividends and imputation credits, you can harness the power of compounding to accelerate the growth of your investment portfolios.

• Diversification benefits – Diversification is a fundamental principle of a sound investment strategy. Including shares that pay franked dividends in your portfolio can contribute to diversification by adding a layer of stability and income generation. In times of market volatility, the consistent cash flow from these dividends can help offset potential losses from other more volatile investments, creating a more resilient portfolio.

• Inflation hedge – Inflation erodes the purchasing power of money over time, making it a concern when you’re seeking to preserve and grow your wealth. Shares that pay franked dividends can serve as an effective hedge against inflation. As companies often adjust their dividend payments to keep pace with inflation and rising costs, if you’re holding these shares, you may benefit from a growing stream of income that maintains its real value over the long term.

• Psychological comfort – Investing is not only about numbers and financial metrics; it also involves the psychological aspect of managing emotions and uncertainties. Shares that consistently pay franked dividends can provide you with a sense of comfort and confidence. Knowing that you can rely on a regular income stream, even in the face of market fluctuations, can help you stay focused on your long-term goals and resist the temptation to make impulsive decisions based on short-term market movements.

The drawbacks of franking credits

While franking credits provide benefits, such as reducing your tax liability, there are some downsides:

• Complexity – The system of franking credits can add complexity to tax returns, particularly if you have investments in multiple companies with varying franking credit levels.

• Market distortion – Some argue that the availability of franking credits may influence investment decisions, potentially leading investors to favour companies with higher dividend yields and franking credit levels over those with better growth prospects.

Summary

In the complex landscape of financial markets, the appeal of shares that pay franked dividends extends beyond the promise of immediate returns. It’s about building a resilient and balanced portfolio that stands the test of time.

The tax efficiency, stable income streams, and the signal of financial health associated with franked dividends make them a compelling choice when aiming to achieve long-term wealth accumulation.

As with any investment strategy, it’s a sensible course of action to conduct thorough research, assess how comfortable you feel about risk, and seek professional advice to tailor your portfolio to your specific financial goals and circumstances.

By embracing the advantages of shares with franked dividends, you can open up a pathway to sustainable wealth and financial wellbeing.

The information in this article is current as at February 2024 and may be subject to change. The information in this article is factual in nature only and does not and is not intended to imply any recommendation or opinion about a financial product. You should obtain appropriate advice before making any decisions based on the information in this article.