I prefer to write about my lifestyle and how the choices I make will in time make me rich enough to forego compulsory work. I believe this is the most interesting part of finance and where the most progress can be made for the vast majority of people. However, I will on occasion take the time to dive deep into an investment topic if it is interesting and generally not very well written about. Also because a great deal of you, my fellow shufflers want to know more about investment as well as lifestyle and saving.
So today I describe to you the absurdity of franking credits. When I say absurd, I mean it in the best possible way. The “I can’t believe this is legal” sort of way.
This seemingly innocuous, tiny tax credit can have huge implications to both the growth of your investments and the income you receive during retirement. It also has a special bonus for those who use any sort of credit to purchase shares.
I find that the best way to think about franking credits (sometimes called ‘tax imputation credits‘), is that they are tax that has already been paid for on your behalf. When you receive Australian dividends, about 80% of those dividends will come with a full franking credit (there are also partial franking credits, but we will cover that a little further down). This franking credit is equal to the 30% tax the company had to pay on the profit they made, which they just gave to you as a dividend. This credit then shows up on your tax return as tax you have already paid!
So for example, a 70c fully franked dividend will come with a 30c franking credit!
Earn $7,000 of fully franked dividends and it is as if you have already paid $3,000 in tax!
Partially franked dividends are those that do not have the full 30% company paid tax attached to them as a franking credit, but somewhat less than this. They still provide an advantage but less so than their fully franked counterparts.
There are also non-franked dividends which are treated just like normal income.
How you are taxed
So when you earn a dividend and a franking credit, you are taxed on the total amount at your marginal tax rate. Following on from the above example…
Earn $7,000 in dividends
Franking Credit = $3,000
Taxable amount = $10,000
Depending on your total income, you may end up with franking credits that can then be used to offset the tax on other income you have earnt. If you end up with more franking credits than tax liabilities at the end of the financial year, then the government will refund you that franking credit!
Let the magic begin – Accumulation Phase
This little phenomenon is hugely important because unlike the yields of other investment vehicles which are taxed, dividend yield that is fully franked has an immediate 43% advantage against those numbers.
For example, a 4% fully franked dividend yield is comparable to a 5.68% savings account yield.
Another way to look at this is if you were paying 30% tax on that 4%, your yield would only actually be 2.8% after tax.
Those familiar with investing already know that a difference of 1.2% is HUGE. With enough time that will be a difference of hundreds of thousands of dollars.
So to make a comparison between franked and unfranked dividends, we will take 2 hypothetical shufflers, Pete and John who each invest in a different company. Pete and John each earn about the same and so sit in the same tax bracket.
Shares in each company have a capital growth rate of 5% per year and a dividend yield of 4%. Company A’s dividends are fully franked, Company B’s dividends are not franked. Pete invests $100,000 in Company A and reinvests all the dividends after tax. John invests $100,000 in Company B and also reinvests all the dividends after tax.
In the very first year, Pete is over $1,100 dollars ahead as per the below table.
Over the course of a lifetime, if all other parameters remain constant, even without investing any more money than that original $100,000 the effects are absolutely staggering.
The difference is about $335,000 when invested and untouched for 30 years.
But why stop there? If we look at a shuffler who is in a similar position to myself:
- with a starting balance of about $200,000,
- adds regular contributions of roughly $35,000 per year; and
- plans to retire in 10 years on $1,000,000…
we see that franking credits can knock just under a year off of a working career.
This is pretty good, but you haven’t seen anything yet.
As if knocking a year off of your time to retirement was not enough, these franking credits really come into their own during retirement!
That is because any excess franking credits you have above your tax liability will get refunded to you. You may not have worked a day during the whole financial year, and the government will have to give you money back come tax time!
Let’s go back to our example of Pete and John. It is sometime down the road and both Pete and John have shuffled their way to retirement, each with $1,000,000 in shares with Companies A and B above. Woohoo, good for them. Pete still has all his income derived from fully franked dividends and John has all his income from unfranked dividends. You would be forgiven for thinking that their incomes are the same at this point, but generous Australian government taxation laws mean their incomes are actually quite different.
As you can see, Pete got a huge tax refund, where John had a tax liability, seriously affecting his spending money during retirement.
So my personal criterion for reaching retirement isn’t actually $1,000,000 but $40,000 in income. To achieve $40,000 in yearly income without the effects of any franking credits, I would need $1,200,000!
The Combined effect
So going back to the example above of a shuffler in roughly the same position as me at the moment, the combined effect of increased gains and needing a lower amount of capital to reach your income target makes for a truly astonishing combined effect.
That is right, 4.5 years longer to attain the same income if you choose 0% franked dividends (n.b. all international shares are 0% franked)
Things get even better
How can this get any better, do you ask?
If you are in the fortunate position of having someone you want to spend your life with, then by splitting the income between the 2 of you, you will also increase your tax refund! Pushing down your years to FI even further.
A bonus for those using credit.
So I suppose you are thinking this is freaking magic right about now. But did you know that those who choose to use a loan of some description benefit even more!
You know how you can negative gear with property? You can do the same thing with shares!
Except if you have 100% franked dividends, the negative gearing occurs even when your investment is actually cash flow positive! Take for example Pete and John again, except this time they are each funding half of their investments through a loan against their investment properties.
As can be seen in the above table both John and Pete received a $4,000 dividend and paid $3,000 in loan interest. John without his franking credits had to pay $345 in tax for his investment this year. On the other hand, Pete, because of Franking credits, actually reduced his tax liability by $778!
At this point I am sure you believe, just as I do that franking credits are pure witchcraft. Witchcraft that I want maximum exposure to.
In summary franking credit can have the following effects if your investments are set up correctly:
- Increase growth rate of your portfolio.
- Decrease the total portfolio size you need to hit a certain income level.
- Can make a positive cash flow leveraged investment still reduce your tax liability for the year.
In my particular circumstance the difference is over 4 year of extra work for a completely unfranked portfolio vs a fully franked portfolio. I’m not the biggest fan of just working my life away. So though it is always important to have very diversified investments, given these extreme taxation benefits I choose to be overweight in Australian shares to increase the Franking percentage of my portfolio.
Shuffling my investments options.
Pat the Shuffler