The Power of Franking Credits in Pension Stage: Boosting Retirement Income
Investing in shares can often be perceived as a risky endeavour for those who haven’t had much experience, particularly for retirees who depend on stable income from the money or assets they’ve accumulated.
However, risk is a relative word that has many variations, (A great book, ‘Against the Gods – The Remarkable Story of Risk’ by Peter L Bernstein is a must read for any real financial professional or person with a thirst for knowledge). Literally nowhere that you hold your money or wealth is risk-free. Even ‘hiding away’ large amounts of physical cash under the proverbial mattress holds many risks, including the loss of potential interest and returns and reduced buying power due to inflation, without even considering the physical risks.
A major consideration is also that not all shares carry the same level of risk. Solid blue-chip companies with solid trading histories, strong balance sheets and long track records of reliable dividend payments with high franking credits (think CBA as an example) will typically hold far less aggregate risk than a start-up venture with high debt and a low capital balance.
These entrenched companies, typically leaders in their industries, have a strong history of profitability and are expected to survive indefinitely. Sure, the ‘disruptors’ and ‘new tech’ companies can also potentially play a role in portfolios and may one day inherit the earth, but from a security aspect, people still love sweet treats (Nestle), get scratches and sores (Johnson & Johnson), and need secure reliable cash transactions (think any of the ‘big 4’ banks in Australia – regardless if you love or hate them).
When looking at solid blue chip Australian shares as part of a diversified portfolio and adopting a strategy where the intention is to hold them long-term without the need to sell, retirees can mitigate the impact of market volatility and capitalise on the benefits of franking credits. (Akin to a good investment property that gives great rent returns; if you have no debt on it nor intention of selling, it’s no great concern to you whether the property market in general is up or down).
These blue-chip shares or managed funds or Exchange Traded Funds (ETFs) that invest in them, can provide an opportunity for retirees to generate good yield or income returns and potential capital growth. If held over the long term, this can also substantially reduce volatility risk i.e. market fluctuations and share prices substantially going down or up.
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What Are Franking Credits?
Franking credits, also known as imputation credits, are a key feature of Australia's tax system designed to eliminate the double taxation of company profits.
When an Australian company pays tax on its earnings and distributes the after-tax profits to shareholders as dividends, those dividends come with a franking credit. The credit reflects the tax already paid by the company, allowing shareholders to offset their own tax liabilities.
For example, if a company distributes a dividend of $70 with an attached franking credit of $30, the total taxable income for the shareholder is $100. Shareholders can use the $30 credit to reduce their tax bill, and if their tax liability is less than the credit, they may receive a refund of the excess – in other words, aside from the $70 dividend, you’d also receive a further $30 from the ATO as a refund.
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Why Franking Credits Are Valuable for Pensioners
Pension-stage superannuation accounts have a 0% tax rate (are tax-free).
This means retirees drawing income from these accounts are not required to pay tax on their investment earnings or withdrawals. Consequently, any franking credits associated with dividends earned in these accounts are fully refundable.
This creates a great advantage for retirees with pension-stage superannuation accounts: they not only benefit from the dividend income itself but also from the refunded franking credits, effectively boosting their total investment returns. For pensioners relying on regular income to cover their living expenses, this additional cash flow can make a meaningful difference.
(This is why when ex-Labor politician Bill Shorten pushed to have franking credits stopped, many retirees and pensioners rallied together, protested and voted in the 2019 elections against that change, preserving their income and to continue to receive a fair tax treatment).
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Reducing Risk Through Blue-Chip Shares
While the stock market in short term periods can be volatile, blue-chip companies -such as major banks, established resource firms, utilities etc – generally tend to offer more stability over the longer term.
These firms will often have resilient business models, strong balance sheets, sound management leadership and a history of paying consistent dividends.
If the intention is to hold the shares indefinitely (and not sell out at the first dip, nor need the capital in the short term for other goals or expenditure) retirees investing in such companies as part of an appropriately diversified portfolio, are less risk-exposed to short-term market fluctuations. ?
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An Example of Franking Credits in Action
Consider a retiree who holds $200,000 worth of shares (or an ETF) of Australian blue-chip companies as part of a diversified portfolio in their pension-stage superannuation account. If these shares/ETF pay a 5% dividend yield, the retiree earns $10,000 in dividends. Assuming the dividends are fully franked, given their pension fund has 0% tax, the franking credits could add approximately $4,285 (based on a 30% corporate tax rate). This means the retiree's total income from that investment increases to $14,285, a significant boost without any additional risk or effort.
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Benefits of Franking Credits in Retirement (low or no tax environment)
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Strategic Considerations
To maximize the benefits of franking credits, retirees should consider allocating a portion of their superannuation to Australian shares with high dividend yields and full franking, or an ETF ?or managed fund that comprises of these.
However, it is also essential to maintain diversification to manage risk effectively. Combining blue-chip Australian share investments with other asset classes - such as cash, term deposits & fixed interest, property, private equity, infrastructure and alternatives, international equities -ensures a balanced portfolio.
Additionally, retirees should periodically review their holdings to ensure the companies in their portfolio remain financially robust and continue to pay dividends. Consulting with an experienced, fully qualified financial advisor can help retirees with their overall position and tailor specific investment strategies to align with their goals, income needs and risk tolerance.
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Conclusion
Franking credits are a powerful yet often underappreciated feature of Australia's tax system that can significantly enhance retirees' income in the pension stage.
By investing in solid, enduring blue-chip companies that pay fully franked dividends, retirees can achieve a reliable income stream while minimizing the impact of market volatility.
Combined with the tax-free status of superannuation-pension income, franking credits provide an excellent way to bolster returns and sustain a comfortable retirement lifestyle.
Combined with a well-planned overall strategy that focuses on adequate capital resources and long-term income stability in retirement, retirees and their suitably experienced and qualified planners can make the most of this unique financial advantage.
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If you require further information on how to get started or any of the above has struck a chord with you, feel free to reach out any way you wish (LinkedIn, telephone, email or other). I have clients all over Australia and the world, and always happy to have an initial discussion without cost or obligation.
* The above is general information only and not personal advice. For further information or a confidential discussion, please contact the author directly.