The ‘Rich’ and Franking Credits
Australia has a marginal tax rate system, which means lower income earners (simply, earning less than $18200) pay not tax and higher income earners pay the most tax, at 47% including the Medicare Levy.
So if we accept these tax rates as a guide, the Australian tax system imposes the highest rate of taxation upon those it considers ‘rich’, earning more than $180,000 per year.
Perhaps obviously, not all taxpayers who earn $180,000 or more are rich. Many will be poor, with very large commitments, long standing debts, and so many other issues besides. They may have just started earning a very high income, and accumulated virtually no assets at all.
A successful real estate agent for instance, may be quickly earning a high income and not know how long the good times will last, and also have very high spending commitments to look the part, by having an expensive motor vehicle and clothes. Turning up to a $60+ million dollar apartment that they are hoping to win the commission for, in an old car wearing a tracksuit might not create the right impression!
But the tax system says someone earning $180,000 a year, should be subject to tax at the highest rate.
Taxable income is not a calculation of wealth accumulation. Instead, it is a fiction around which taxation and financial affairs are used to determine a level of tax exposure for a defined period of time. Usually a year.
For instance, ‘tax free’ pensions and income streams are not included, and unrealised capital gains are not included. Your employment income might be $60,000 and your share portfolio could go up by $1 million in a 12 month period, but your taxable income can stay at just $60,000.
So taxable income has very little to do with wealth accumulation.
But what if your ‘taxable income’ is $180,000, and you do not need to work, with all of the income coming from investments?
How ‘rich’ are you?
This is where more variables come in, because it will depend upon the rate of return, and how much of that return is included to taxable income.
For example, investments in some shares (eg banks) might produce a dividend return of around 5.5%. If the dividends are fully franked, the grossed up taxable return is closer to 7.85%.
To generate a taxable income of $180,000, the investor will need $2.3 million to hit the highest tax rate. Cash dividends of $126,500 will be received, and the remaining amount is the franking credit of $53,500.
The franking credit represents 30% of their ‘income’.
When they lodge their income tax return, they must report $180,000 as being their taxable income, despite living on the $126,500 received for the year.
They might be enjoying their retirement, or an early retirement, enjoying travel, gifts to children and grandchildren, and all the things that they have worked during their lives, made sacrifices and accumulated their nest egg.
The total tax calculated on their taxable income of $180,000 is around $57,832. This includes the medicare levy, and no tax offsets.
Fortunately, they have the franking credit from their dividend income, of $53,500. All of their income has already been subject to tax, in the company that they hold shares in.
So they will still have a tax bill to pay of around $4332 ($57,832 - $53,500).
The tax bill, represents the additional tax at a personal level, compared to the corporate tax that they have already paid.
But we are often told not to have all our eggs in one basket. By spreading your portfolio the investor might find that the banks produce relatively higher dividends, and other share investments produce much lower rates of return (in the hope for higher capital gains and increasing dividend income, over time, to help match increasing living expenses).
So by having a diversified portfolio of shares with varying rates of return, the investor might find that their overall portfolio dividend return drops to around 3%, and fully franked dividends are only around $70,000.
Their franking credits of $30,000, boost this to a taxable income of $100,000.
When it comes to their annual income tax return, their tax exposure is $26,632 (including medicare).
Because they have already paid $30,000 via the companies that they have invested in, they are entitled to a tax refund of around $3368.
This is because franking credits are ‘refundable’ tax credits.
However, this is what is proposed to change by one major political party, which has caused such an uproar in March 2018.
The proposal is to make these tax credits ‘non-refundable’.
So upon lodging the income tax return, the taxpayer will be assessed as earning $100,000, and will lose the ‘excess’ tax they have paid via the companies in which they invested.
Their nest egg of $2.3 million will provide them a lower rate of return.
Curiously, the investor with $180,000 in income will enjoy the full benefit of all of their franking credits, but the investor with $100,000 in income will not.