The RBA will announce its decision on the official cash rate this afternoon, with almost every economist predicting interest rates will remain on hold… which isn't great news if you're relying on cash in the bank to grow your wealth or fund your retirement. A 2.5% cash rate just won't cut it for holders of term deposits, and rising property prices mean rental yields aren't what they once were. And neither of them are particularly tax effective… especially compared to shares. I'm taking events into my own hands!
Read on for how I'm beating the tax man — and how you can, too!
But first, a lesson or two on tax, and investing, from Kerry Packer.
Lessons from The Big Fella
Ah, Kerry Packer. They just don't make 'em like that, any more!
A smoker and gambler with a larger than life personality, Packer was a business titan, who inspired incredible loyalty among his troops… and trod on more than a few toes in his time. And by God, he was quotable.
On death:
"Last year I suffered a major heart attack and died. I didn't die for long but it was long enough for me. I didn't come back to control John Fairfax. I didn't come back to break the law. And I certainly didn't intentionally come back to testify before a parliamentary inquiry."
On Alan Bond:
"You only get one Alan Bond in your lifetime."
That one's well known, but this lesser-known quote was prophetic:
"Sport, first I am going to take three years off. Then I'm going to come back and buy television stations for half the price their new owners just paid for them. Then, son, I'm going to have some fun."
But perhaps Kerry Packer's best known quotes are the comments he made to a Senate inquiry in the 1980s. He started well, when asked to state his name and the capacity in which he appeared:
"Kerry Francis Bullmore Packer. I have appeared here reluctantly."
And his zinger on tax:
"Of course I am minimising my tax. And if anybody in this country doesn't minimise their tax, they want their heads read, because as a government, I can tell you you're not spending it that well that we should be donating extra!"
Now, we can all take different views when it comes to government policies — and how well either side of politics spends the tax revenue they collect — but we're with Kerry Packer — and Warren Buffett, for the record — when it comes to not paying more tax than is necessary.
When it comes to building your wealth, one of the best ways to minimise the tax you pay is to take advantage of fully-franked dividends.
Not all investment returns are equal
When you put money in the bank, you pay tax at your marginal tax rate.
When you invest in property, you pay tax at your marginal tax rate.
But…
When you invest in shares of a company that offers fully-franked dividends, you pay tax at a much reduced rate… and in some circumstances the ATO will even send you a refund cheque! Let's take a return of, say, 5% on a $100,000 investment. Whether you've invested in cash, property or shares, that's a $5,000 pre-tax gain. If you're paying the top marginal rate of 46.5% (including the Medicare levy):
- Your bank deposit will earn you an after-tax return of $2,675
- Your property rental will earn you an after tax return of $2,675; but
- Your fully-franked dividend will earn you an after tax return of $3,821!
Yes, you read that right — an identical pre-tax return provides an after-tax return that is fully 43% higher for shares than property or cash!
Or, to put it another way, your marginal rate of 46.5% falls to 23.6% for that fully-franked dividend… effectively chopping your tax rate (for that return) in half.
Have I got your attention? I thought so!
Because if your tax rate is 38.5%, your tax rate falls to 12.1% for that fully-franked dividend. If it's normally 34%, you'll only pay 5.7% — one-sixth of your regular tax rate.
Your Six-Monthly Bonus From the Tax Man
But what if you're paying 20.5% currently? Or not paying tax at all?
If you're on the lowest 20.5% tax rate and you received $5,000 in fully-franked dividends, the tax man would actually pay you $679. And if you're under the tax-free threshold, or you don't pay any income tax — say, for example, in an SMSF that's in pension phase — the ATO will sling you a cool $2,143 for your troubles… on top of the $5,000 dividend you received.
It's like a six-monthly bonus straight from the tax man!
An SMSF in pension phase would end up with a post-tax return of $7,143 from our hypothetical $5,000 dividend!
The beauty of fully-franked shares
No matter your tax rate or whether you invest inside or outside of super, an identical pre-tax return will always give you a better post-tax return when it comes from a fully-franked dividend, rather than bank interest or property rent!
Ah, but aren't shares risky? It depends what you mean by risk!
Are they volatile? They sure are — as you'd expect from an asset that's traded on a public market every business day of the year. Your house or investment property probably changes hands only every 5 or 10 years or so.
Can't I lose money? Absolutely. If you invest in the wrong asset and pay the wrong price, you really can lose money — but that's true for shares, property, artwork or precious metals, including gold!
Let's take an appropriately long-term investment horizon. Fund manager Vanguard helpfully compiles a 30 year comparison of shares, property, cash and other assets. Over the 30 years to June 30, 2013, shares (as measured by the All Ordinaries Index) had delivered a compound return of 11.6%, listed property had gained 9.9% and cash gained 8.2% — assuming proceeds were reinvested.
On another measure — the ASX and Russell Investments 'long-term investing' report — shares beat residential property, listed property and fixed interest over the 20 years to 2012.
Yes, individual shares can fall in value — as can individual investments in a single property or one bond. But, historically at least, shares as an asset class have outperformed handily… and all of those numbers above are before the inclusion of franking credits for fully-franked shares!
(And we should add that, for all asset classes, past performance is no guarantee of future performance.)
A very useful tool, indeed
Now of course, we wouldn't suggest that you let the fully-franked tail wag the investing dog — it's after-tax returns that matter, not your tax rate. And, of course, the capital return matters, too… a lot.
But as the numbers above show, shares have historically performed very well, despite the All Ordinaries including plenty of very low quality businesses.
If you can create a portfolio of quality businesses selling for reasonable prices and offering fully-franked dividends, you stand a very good chance of creating meaningful wealth.
