How to Fat FIRE on $137k per year without paying tax
One of the most important aspects for most retirees, particularly in their investment strategy, is franking credits and the increase in income that it delivers. The increase in income that is offered by franking credits is a key aspect that most investors adopt when setting their retirement goals. Also, the credits offer a boost of about 1.5% on average dividend yield on shares. However, the benefits of franking credits may be negatively impacted if Labor proposes limitations on access to the credits like they did in the most recent federal election.
Retirees, as well as people thinking of retiring soon, need to understand franking credits, as well as possible effects of changes on these credits on their portfolios. Another thing investors need to consider is the indirect effect of these changes on the Australian equity market. Also, it is important for retirees to not only include franking credits to their retirement strategies but also know how to make necessary changes to these strategies if the franking credit system is altered.
About Franking Credits
The concept of franking credits was introduced in 1987 as a way of providing solutions for issues relating to double taxation. With this, investors in Australia can claim credits on already paid tax and use it to offset other bills.
After the concept was introduced, it became popular at a fast rate, but it was not until the early 2000s that the credits became refundable. The implication of this is that for cases where the credits exceed tax liabilities, investors can go to the tax office for cash payments.
Franking credits are also known as imputation credits, and these credits are usually offered for investors who collect dividends from tax-paying countries in Australia. The credits reduce the incidence of double tax payments by shareholders. It is worth mentioning that franking credits are applied as a tax offset, which is why they are referred to as credits.
Importance of Franking Credits for Retirees
As stated earlier, franking credits is very important for retirees. A retiree that has a tax rate of 0% can receive as high as 43% on the cash value of a franked dividend. On the other hand, if a retiree earns $2 of unfranked dividends or capital gains, the value will remain unchanged.
In general, only a few retirees usually have their portfolio in franked shares, although this can be adjusted, especially if franking credits become restricted. It is important to note that without access to franking credits, what a retiree will be able to consume during retirement will reduce by 5 to 6%.
As a matter of fact, restricting franking credits has a more adverse impact on retirees. In some cases, some retirees may be forced to lower their standards of living or alter their retirement goals if there's nothing much in their investment portfolio (other assets or unfranked stocks).
Purpose of Franking Credits
As stated earlier, franking credits allows investors to earn the credits as a tax refund, and for other investors, it's an avenue for them to reduce what they pay on dividends. However, there's more to franking credits. From a general point of view, most companies pay taxes on what is distributed to their shareholders. Also, dividends are often regarded as income, which is why investors are taxed for these dividends. However, since the company has already been taxed by the ATO, it eliminates the need to pay additional tax on these dividends.
Before the introduction of franking credits, earnings from companies were taxed twice. The first one is usually when the company pays taxes for earnings, and the second is taxed on the shareholders. Also, before franking credits were introduced, the general belief was that it would be better to reinvest profits in companies because it can boost share price instead of paying a higher dividend. This was the public sentiment, and even the companies weren't left out on this.
For instance, if a company distributes $100 earnings as dividends after paying full tax, which is 30%, what the shareholders will receive a dividend is now $70. Now, if this amount was paid to an investor who is currently in the highest bracket, which is 45c for each dollar, the only thing the investor will end up with is $25. It was issues like this that brought about the introduction of franking credits. Today, the main people that benefit from these credits are retirees, especially with Australian stocks.
Now, if a retiree receives $70 from a company that already paid the complete 30%, the retiree will earn $30 from the ATO as franked credits.
Calculating Franking Credits
Still wondering how we arrived at the values above? Here's an equation to help you understand the concept better.
Therefore if a company pays the full tax rate which is 30%, and receives $150 which is also fully franked, it implies that:
Franking credit = ($150 x 0.3 x 100%) / (1 – 0.30))
= ($45 / 0.70)
Therefore, for $150, the franking credit is $64.29
It is important to note that this example may not apply at an individual level, so here's how it works at an individual level.
Let us assume that Abel is a shareholder of an Australian company. If this company pays Abel $150 as franked dividends, then from the example above, we can deduce that the franking credit he'll receive is $64.29, which is already paid by the company. If Abel decides to fill his tax return, he'll be able to add the $64.29 franking credit to make $214.29.
There are three possibilities here, depending on his marginal tax rate, and this includes:
Abel can receive an excess tax refund that could be used in paying for tax on other income if his marginal tax rate is less than 30%. However, if Abel does not pay income tax like most retirees, he's likely to get a cheque for the excess tax credit.
If the taxes he pays on the franked dividend is the same as his marginal tax rate, then he's unlikely to receive an excess tax refund. However, he won't need to pay more tax
The last possibility is in the event where his tax rate is above 30%. If this is the case, Abel will not receive a refund of his franking credit. He will also have to pay excess tax. Therefore, if his tax rate is 50%, he will need to pay the extra 20% on his franked dividend, while the remaining 30% is what his company has already paid for. With this, whether his tax is more than 30% or not, he will still enjoy the benefits of the franked dividends.
Investments that Pay Franking Credits
For companies that earn revenues outside Australia, they are not required to pay company tax or franked dividends. On the other hand, companies with profits in Australia will pay company taxes, and if they pay in full, shareholders will earn tax credits based on the company rate of 30%.
If a company carries losses forward or does not earn profit within a financial year, the company may be subject to lower their tax rate or no tax rate at all. The result of this is an unfranked dividend or partially franked dividend.
Franking Credits and SMSFs
SMSF represents Self Managed Superannuation Fund. Trustees of SMSF can lower their tax liability if they decide to invest in fully franked Australian shares.
As mentioned earlier company tax rate is generally 30%, especially for businesses with a gross turnover threshold of $50mil. However, for SMSF, the amount of tax paid is only 15% which is enticing if the SMSF buys fully franked stocks. It makes it easier for them to reduce their tax bill, especially if their investment portfolio consists mainly of franked securities.
Therefore, for an SMSF that receives a fully franked dividend, the tax on the dividend will be paid by the franking credit. The SMSF can also use franking credits to reduce other profits, including rental income, tax on contributions, and capital gains. If the SMSF does not have any taxable income, the ATO will give them a refund.
The 45-Day Rule
In Australia and other countries that offer franking credits, there is a holding period of 45 days, of which purchase dates and sell dates are included. To be able to lay claim of franking credits, a shareholder will be required to hold stock for a minimum of 45 days. The franking credits on dividends will not be received if the share is not kept for up to 45 days.
The aim of this rule is to ensure that shareholders who only keep stocks for a limited period cannot claim franking credits if they sell the stocks, whether they qualify for the dividend or not. It is worth mentioning that the rule covers SMSFs, companies, and individual taxpayers.
However, there are people who are exempted from the 45-day rule. Private and small shareholders are exempted from the 45-day rule. This exemption mainly applies for shareholders with franking credit below $5,000.
ETFs Investments in Australia
ETFs have become so popular across Australia, and this is mainly because they are tax-efficient and high ease of entry compared to other available investments. For example, unlike Listed Investment Companies, and managed funds, ETFs pay out less capital gains, and they also have a lower turnover. What's more, is that ETFs investors get a lower tax bill.
One of the reasons why ETFs are tax-efficient is because of the lower portfolio turnover they have. This is also because their investments are not bought or sold frequently, and as such, they are more likely to incur lesser capital gains tax, unlike other alternatives.
ETFs also trade more on the Australian Securities Exchange and other stock exchanges, which helps to make them more tax efficient. Also, it's very unlikely to see an ETF selling shares for profit or to raise funds to pay investors.
The Tax Benefits of ETFs
ETFs offer better tax outcomes in the following ways:
ETFs reduce capital gains tax liabilities better than actively managed funds
The reason why ETFs hold a portfolio of assets and shares is to help it track the index better. This implies that the portfolio is determined by the index, meaning that whatever changes that may affect the index will also affect the portfolio. However, with actively managed funds, it is the responsibility of the fund manager to decide the shares that will perform better.
This is the reason why actively managed funds sell their shares too frequently, unlike the index process. When shares are sold too frequently, it increases the capital gains tax liability of investors.
ETFs help in reducing and removing tax burden risks from investors
ETFs are also traded on ASX-like shares, which is an added advantage for investors when compared with unlisted funds. For these unlisted funds, the shares are usually sold to pay investors, and investors cannot withdraw themselves. Again, the sale of shares only further increases capital gain tax liabilities.
Also, when investors withdraw funds too frequently, the tax burden increases, and this can cause stress for the investor. Unlike unlisted funds, withdrawals do not occur too frequently with ETFs, and for every investor that wishes to withdraw, all they need to do is to sell their units.
ETFs can access franking credits
Companies that pay tax to the ATO can add franking credits to their dividends to get tax credits. Australian residents who don't have tax liability will also be credited by the ATO for the franking credits.
For an ETF with shares that pay franked dividends, the investors will benefit from the franking credits, which they can use to reduce tax liabilities. It is worth mentioning that it is the shares portfolio of the ETF that determines the franking credits flow.
Reduced tax for long-term investments
By law, owning an investment for as long as 12 months will help you reduce the capital gain tax by 50%. With this, you'll only pay half of the tax. What's more, is for SMSFs, the discount is one-third. The 12-month rule is mainly for ETFs that hold REITs.
An in-depth Illustration of Franking Credits and Retirement
Here's an illustration to help you understand the differences between unfranked and franked dividends:
David and Daniel both earn around the same amount, which places them in the same tax bracket. They separately decide to invest in different companies, of which each company offers a yearly capital growth of 5% and a dividend yield of 5%. However, the dividends of company X are fully franked while that of Company Y are unfranked.
David invests $200,000 as well as his dividends after tax in company X, while Daniel does the same with company Y. It is important to note that both David and Daniel are in the 37c tax bracket. In the table below, you'll see that David is already over $2,000 ahead of Daniel after the first year.
As years pass by, the difference between these two investors becomes more glaring, with more advantages and earnings for David in the long run.
Continuing from the example above, David and Daniel have both come up with strategies for their retirement with $2,000,000 shares for their respective companies. David is still earning his income from the fully franked dividends, while Daniel's income remains unfranked. You might want to think that they are both earning the same thing. However, their incomes are different, based on the Australian government taxation laws.
Here's an illustration of their franking during retirement:
From this illustration, you can see that David has a higher tax refund, whereas Daniel only incurred tax liability which now affects what's left for him during retirement.
Still wondering how you can Earn ~137k without paying any tax?
Here’s an illustration from the above table to show you how David can achieve this assuming 100% franking credit:
For David to avoid paying tax, he’ll need a dividend amount of $136,887.
This strategy is really only effective for shares with a franking credit that does not change from distribution to distribution. Thus, only unfranked and fully franked stocks can be calculated ahead of time. For the fully franked option, you will also need to overestimate your potential dividend yield (e.g. 7-8%) so you will have less need for a large portfolio and you’ll end up with a tax refund if the yield ends up being the long term average (4%) so you’ll need to ensure this amount will be enough or even whether 2% (~$34k and the lowest dividend yield in the last 3 decades) is enough during downturns in the market.
Of course all these is purely a fun hypothetical situation to see how to achieve a tax free portfolio. I also thought it would be good to show people who shun high dividend yield equities because high growth ETFs/stocks have less tax burden that it’s possible to pay no tax and even get a tax refund.
In practice, you wouldn’t care about paying tax because you will still end up with a higher dividend amount the more you invest for your ideal lifestyle post FIRE. That being said, $137k/year is well into the Fat FIRE category that it should be sufficient for many people pursuing FIRE.
Fully Franked Options
We have spoken a bit about fully franked dividends. But which listed companies offer this option? Well go no further than below:
Did I miss any or get anything wrong? Will amend as required.
(https://kalkinemedia.com/au/dividend-yield, https://www.ig.com/au/news-and-trade-ideas/top-5-asx-dividend-stocks-to-watch-in-august-2021-210811, https://www.fool.com.au/2021/05/13/these-asx-dividend-shares-offer-generous-fully-franked-yields/,https://www.stockmetric.net/asx-indices/asx300/).
Pros and Cons
A requirement for companies is to pay tax on annual income every financial year. These companies also pay out dividends from the profit made after paying taxes. Therefore, this implies that it is the company's responsibility to pay taxes, irrespective of whether the company shares dividends or not. This might not be an advantage for the company, but it's a huge one for investors.
Franked dividends usually come with an additional tax credit. This implies that investors can avail the tax credit and also request for a tax refund. It is worth mentioning that tax rates are usually higher with corporates than personal income (tax free up to 30% tax bracket if fully franked). Therefore, investors can get a refund if they comply with other provisions.
You can rely on a more stable and higher income source than a Living Off Equity (LOE) strategy and less tax if your dividends are fully franked and distribution is below ~$137k.
Easier to calculate your target passive income for FIRE as dividend yields are less volatile (between 2-7% yield with average/median yield of 4% in last 3 decades) than capital gains. More stable for LICs.
Less risk that you are forced to work again due to insufficient nest egg.
If you buy LICs, you can turn on DSSP so you can defer tax to the future.
Even though franking credits has so many advantages, there are also a few disadvantages.
For example, it can cause an increase in the circulation of free cash flows, which will result in a reduction in the amount of available cash for use. This will ultimately lessen the liquidity, which can hinder the growth of the company in the long run.
Fully franked dividends means that your portfolio are not as diversified because only a select few (as seen in the table above) offers it so it may not be a suitable strategy.
Total returns can be lower than one with less distribution as they use it to invest back into the company. You could mitigate this risk by having a high growth and diversified portfolio inside super.
You don’t get to drink the cool-aid like most of the FIRE community and get 50% discount on CGT with a lower untaxed income ceiling.
The franked dividend is the dividend that a company pays to investors after paying tax, of which the investors receive franking credits. These credits can help to ease, even eliminate the tax burden of these investors. Franking credit is very important for investors, and many now use it to minimise taxation. This is why it was such a big deal in the 2019 Federal Election.
The power of Fully Franked Dividends of certain Stocks and LICs shows that it is very possible to Fat FIRE on $137k/year without paying tax, with a long-term average of $68.5k (excluding tax refund) and a likely minimum of ~$34k during downturns.
Next time a smug proponent of a high growth portfolio mentions the tax burden of a higher dividend portfolio, you can link them to this post.
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