Franking credits: From little things, big investments grow
I HAD a great experience last week. I was at a conference for financial advisers and there were three speeches on the same phenomenon: What do we have to do so our clients, especially our retired clients, won't run out of money?
It was a special moment because, until then, all the conference talks I have been to have focused on how to make more money.
They show nice graphs where the earning always increase. The fact that many people run out of money during their retirement and then have to rely on the age pension was ignored and put in the too hard basket.
To everyone's surprise two words were used so often that people started bursting out laughing when they were mentioned AGAIN - "franking credits". These two words are a slightly arcane term for something very important for retirement. Let me explain…
An analogy: when a woman gets pregnant, depending on her BMI, she puts on about 50 grams a day for nine months. 50 grams is almost nothing. Our weight can fluctuate daily and by around 1,000 grams with every meal. But the steady, daily increase of 50 grams over the nine months makes a huge difference. Approximately 14 kilograms is slowly added with the daily, or even weekly increase being barely noticeable.
Franking credits work in a similar way. They add about 1.5% per annum to an Australian share portfolio - it sounds very little but like the 50 grams, this 1.5% can transform retirement calculations for the better.
For example, as a rough rule of thumb you can spend 4% of your money each year if you are properly invested. An extra 1.5% is now a big deal. You can spend 5.5% of your income instead of 4%.
In real figures that is $41,000 per annum instead of $30,000 for a $750,000 portfolio (or $82,000 instead of $60,000 on a $1.5 million portfolio) that you can spend without in most cases running out of money. The extra 1.5% can make a substantial difference to your portfolio and your income.
How do franking credits work? It may sound complicated but it is actually fairly straightforward.
Basically, tax only needs to be paid once within Australia. When a non-Australian company earns $100 they pay, for example, $30 in tax and can give $70 to investors. For the investor, this $70 counts as income, income on which they will have to pay tax again.
If the company is Australian and the investor is Australian, there is a crucial difference: the investor does not get $70 but gets $100. $70 of the $100 in cash, and the other $30 as a tax credit.
If the investor pays no tax, as pension accounts don't, then every September the ATO pays the $30 to the investor. If the investor pays tax, the $30 gets deducted from their tax bill. The strange thing is that this free lunch for Australian investors really is free.
There is a lot more to the story, but the outline is clear - the extra money from franking credits can make a substantial difference to your investments and for those in danger of running out of money the extra money often makes all the difference.
* CHRISTOPH SCHNELLE is the principal of In Your Interest Financial Planning Pty Ltd and Auth Rep 308223 of FYG Planners Pty Ltd AFSL 224543. This information is general in nature and readers should seek professional advice specific to their circumstances.