How franking credits enable you to be $558,000 richer in retirement

The average Aussie needs a whopping $2.7 million to retire, but there’s a simple way to add $558,000 to your stash without doing any extra work.

Most people I talk to have pretty big financial goals. It’s not that they want to have piles of money to roll around in, but just that living well in Australia doesn’t come cheap.

If you want to have a good house in a nice area, provide well for your family, loved ones, or community, and eventually have the ability to retire on something close to an average salary, you’ve got some serious work to do.

How much do you need?

I’ve calculated that to have an ‘average’ retirement in Australia today, you need to have around $2,744,443 in investments. This amount of wealth would buy you a home at the average property value across Australia’s capital cities of $926,107, and would also give you an investment portfolio worth $1,818,336, which assuming an income return of 5 per cent would generate you the Aussie average income of $90,916.

Building wealth of $2.7 million is no small feat, so you need to give yourself every possible advantage.

For individuals, investing tax smart is one area that can make a big difference to how quickly you get ahead. Different types of investments have different tax treatments, so the difference between a great strategy and an OK strategy can mean the difference between hitting your targets and falling short.

To have an ‘average’ amount of money in retirement you need more than $2.7 million in investments, including property. Picture: iStock

Hello franking credits

Most companies in Australia that are listed on the stock exchange pay out some or all of their profits each year to shareholders in the form of dividends. Because company tax has already been paid on these business profits, when investors receive dividend payments the ATO is kind enough to not double up on the tax payable on this income, so the majority of dividends in Australia are paid with ‘franking credits’ attached to them.

This can seem confusing, but in reality it’s pretty simple. When profits are paid out to shareholders through dividends, the tax that’s already been paid on the profits is recorded, then when you submit your tax return and include your dividend income the tax already paid counts to reduce the amount of tax you owe.

In short, the impact on your tax is the difference between your tax rate and the tax rate paid by the company paying your dividends. This can be a positive or negative difference. For instance, you can owe tax, or tax can be owed to you.

For example, if your current marginal tax rate is 39 per cent (for an annual income above $120,000) and the tax on your dividends was paid at the company tax rate of 30 per cent, you will only need to pay the difference of 9 per cent tax. Not bad, but it can get even better.

If your tax rate is 19 per cent (you’re earning income up to $45,000 annually) and again tax has been paid at 30 per cent you actually receive a tax refund on your dividends of 11 per cent. This amount is paid as part of your tax refund and isn’t something that just carries forward to future tax years.

The impact on your tax is the difference between your tax rate and the tax rate paid by the company paying your dividends. Picture: iStock

How much impact do franking credits really have?

I wanted to illustrate this with an example showing the difference between having your investment income made up of franked dividends vs unfranked dividends, assuming your aim is to replace the average Australian annual pre-tax salary of $90,916. The tax that would apply on this salary under the current tax rules is $21,863, meaning that the net after tax income is $69,053.

If you were looking to replace this level of income with investment income that doesn’t come with franking credits attached, you’d need to replace the full amount of $90,916 and then pay tax at marginal rates to be left with $69,053 after tax.

But if you were to build dividend income that was fully franked with tax paid at the company tax rate of 30 per cent, you’d only need to receive dividends of $63,000 which would come with attached tax credits of $27,000. The result is that you’d end up with the same amount of income after tax, but need less headline income (and therefore wealth) to get there.

For the engineers, teachers and other analytical types out there, the working on this is shown below:

Franking credit = (dividend amount / (1-company tax rate)) – dividend amount.

Or:

Franking credit [$27,000] = (dividend amount [63,000] / (1-company tax rate [30 per cent])) – dividend amount [63,000].

The implication of this, going back to our initial investment income assumption of 5 per cent, means that you can have less in your investment portfolio to generate the same level of income.

Investing in companies that pay franked dividends means you don’t have to pay tax on your investment income.

Once retired, to generate an income of $63,000 assuming a 5 per cent income rate, you’d need $1,260,000, compared to the $1,818,336 needed if your investment income doesn’t come with franking credits.

This reflects a difference of $558,336, and means no matter how much you’re saving, if you’re investing into companies that pay franked dividends you’ll build your target level of wealth sooner.

Beware of your risk

I have to call out that the above is a fairly simple example, and there are a number of considerations when it comes to building wealth – not least of these being diversification.

While Australian shares are great, the Aussie share market is small relative to the rest of the world. Having your investments concentrated in one country is something that comes with risk.

Every money option comes with benefits and downsides. The key to making the smartest moves for you means understanding your risks and which are right for you.

The wrap

If you want to live a reasonable lifestyle in the future, you’re going to need to put in some work to get there. Every hack you can use on your wealth building journey can help you get to where you want to be faster or easier (or both).

Take the time to understand the rules and how to use them to your advantage, the different investments you can include in your portfolio, and get tax smart when you invest.

Ben Nash is a finance expert commentator, podcaster, financial adviser and founder of Pivot Wealth, and author of the Amazon best-selling book ‘Get Unstuck: Your guide to creating a life not limited by money’.

Ben has just launched a series of free online money education events to help you get on the front financial foot. You can check out all the details and book your place here.

Disclaimer: The information contained in this article is general in nature and does not take into account your personal objectives, financial situation or needs. Therefore, you should consider whether the information is appropriate to your circumstances before acting on it, and where appropriate, seek professional advice from a finance professional.