Legal way to pay a lot less tax when investing

A “quirk” in the Australian tax system means it’s possible to pay a lot less tax – to the tune of almost $30,000 a year.

In today’s cost of living crisis, every dollar counts. Many people are struggling to keep up, let alone get ahead.

But at the same time, there’s so much opportunity in investment markets, meaning if you can find a way to invest, you’re likely to come through this period of disruption in a much stronger position.

If you want to get ahead, you need to use the rules to your advantage.

Enter franking credits.

The true definition of success with money is when you replace your salary with investment income. That means over time you’ll build an income of tens of thousands per month, or probably even into the $100k+ territory.

If you’re not tax smart with this investment income, you’ll pay a lot more tax than you need to – meaning you have to work harder just to get to the same position.

Saving tax is one way you can get ahead faster without just sacrificing more.

How to get more tax credits

In Australia there’s a quirk in the tax system that can make you serious money when you invest. This opportunity comes from the fact that when you invest with shares, you receive part of the company’s profits paid out as ‘dividends’.

With Australian companies, often dividends are paid from after tax profits, i.e. the company earns a profit, pays tax on that profit, and pays out dividends from this money after company tax has been paid.

Legal way to pay a lot less tax when investing. Picture: NCA NewsWire / Monique Harmer

Because this company profit income has already been taxed, the ATO in their benevolence are kind enough not to tax this income twice. How this works in practice is that you as the investor receive a tax credit attached to your dividend to reflect the company tax paid. This tax credit is referred to as a ‘franking credit’, and when dividends are paid with franking credits attached they’re referred to as ‘franked dividends’.

In Australia, the company tax rate is around 30 per cent depending on the size of the company, and because personal marginal tax rates are up to 47 per cent, in most cases you can receive this franked dividend income without paying much extra tax, sometimes without paying any at all, and sometimes you even get a tax refund.

These tax credits will seriously move the dial in terms of how much you need to have in investments to deliver you your ideal level of after tax income. If you’re just getting started investing the numbers may start small, but will grow to become huge as your investment income builds.

In most cases you can receive a franked dividend income without paying much extra tax.

Consider this example.

In Australia, the average ABS before tax income is $98,218. Based on the current tax rates, when you earn a before tax income of $98,218, you would pay tax of $22,218, leaving you with an after tax income of $76,000.

Let’s just imagine for a second that this is your ideal level of income. Not saying that it is, but the logic here applies regardless of your income target.

If you were aiming to have enough investments to give you this level of income, and your investments were in things that didn’t pay franked dividends you’d need to replace the full income, then pay tax, then be left with $76,000 in after tax income.

Assuming a 5 per cent rate of income, you’d need to have around $1,964,360 in investments to receive $76,000 p.a. of after tax income.

On the other hand, if you had investments that paid all of their income in franked dividends that had tax paid at the company rate of 30 per cent, to get the same after tax income you’d need to have investments of $1,375,060 using the 5 per cent income rate.

This $1,375,060 would pay you total franked dividends of $68,753 and come with tax credits of $29,466, resulting in a total income + tax credits of $98,218.

For the maths nerds and detail focused people, the working on this is below:

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

Or:

Franking credit [$29,466] = (dividend amount [$76,000] / (1-company tax rate [30 per cent])) – dividend amount [$68,753].

This shows you can have $589,300 less in your investment portfolio and receive the same level of income, meaning you’re just as ‘wealthy’ but with less wealth. This shows the power of smart tax planning.

And the best part is you don’t need to actually do anything other than invest into the right companies.

Franking credits enable you to receive the same level of income while investing less. Picture: iStock

If you want to leverage these tax credits as part of your investing strategy, it’s important you get your investments structured right from the start – it can be tricky to restructure things after you’ve built up your investments.

You should note that this is a simple example and there are a lot of factors to consider when it comes to setting up the best investment portfolio for you. Tax is one of them, but diversification is also very important. Given the Australian share market is small compared to the total global share market, having all of your investments sitting only in Australian shares comes with some risks.

But this example does show the power of being considered with your tax planning when you invest, and how you can use the tax rules to your advantage to get more out of the same money.

The wrap

Today with the cost of living, interest rates, and the rental crisis, it’s harder than any time in the recent past to get ahead. But on the flip side, the opportunity that exists for investors today is huge. If you want to make progress and set up the future you really want, you have to find a way forward.

Using the rules to your advantage will help. This gives you more money to get ahead, save and invest for the future, or just spend on today – without just budgeting harder or sacrificing more.

Ben Nash is a personal finance and investing expert commentator, financial adviser and founder of Pivot Wealth. Instagram | Facebook | Podcast

Ben is also author of Replace your salary by Investing and Get Unstuck, and runs regular free online money education events, 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.