As a guy who advocates for dividend focused investing, I’ve had a lot of questions about the possible changes to franking credits.

And how this affects the strategy of investing in Aussie shares for income, as well as what this means for listed investment companies (LICs) and those looking to live off dividends more generally.

I’ve given some thoughts on this before in the comments section when asked by readers. But the topic really deserves its own article.

Before we dive in, let’s acknowledge I’m just a random 30 year old blogger with no finance qualifications. Not only that, but the franking changes are a long way off becoming legislated!

So as always, this isn’t advice and everyone needs to decide what’s best for their own situation.

How franking credits affect different investors

Whether the changes affect you or not, is really dependant on your personal tax rate.

Let’s use a common fully franked dividend yield of 4%. Shareholders receive this 4% dividend in cash. The franking credit is simply a tax credit with your name on it. When the value of franking is included, the gross yield becomes 5.7%.

Investors are currently taxed in the following way:

Investor A. 5.7% gross yield, less 45% tax = 3.1% net yield after tax. (4% cash dividend, less extra tax owing)

Investor B. 5.7% gross yield, less 37% tax = 3.6% net yield after tax. (4% cash dividend, less extra tax owing)

Investor C. 5.7% gross yield, less 30% tax = 4% net yield after tax. (4% cash dividend, no tax payable or refund owing)

Investor D. 5.7% gross yield, less 15% tax = 4.8% net yield after tax. (4% cash dividend, plus 0.8% franking refund)

Investor E. 5.7% gross yield, less 0% tax = 5.7% net yield after tax. (4% cash dividend, plus 1.7% franking refund)

Basically, the difference between your personal tax rate and the company tax rate either means you’re owed a refund, or you have to pay some out of pocket tax on your dividends.

And here’s how it looks under Labor’s proposed changes…

For Investors A, B, and C, it’s steady as she goes.

Because their tax rate is 30% or higher, they aren’t entitled to a refund so their numbers don’t change. The franking credits are still able to be used to reduce the tax owing on those dividends, just like before.

So these investors are still looking at a net yield of between 3.1% and 4%.

But for Investor D and E, they lose their franking refunds. So they’ll continue to receive 4% cash dividends, but no longer have the excess franking credits refunded to them.

Clearly this sucks for people on low tax brackets. But it has no effect on those paying 30% tax or above. The lower your tax rate, the more you lose.

Obviously, that’s a negative for those of modest means using Aussie dividends as their chosen source of retirement income.

What will happen to share prices?

My guess is, shares in high yielding Aussie companies would most likely drop in value, as retirees become dismayed at their loss of income and look for yield elsewhere.

But I expect any falls to be limited, unless accompanied by economic issues. Reason being, the Aussie sharemarket is not expensive at the moment. In any case, the long term fundamentals are sound.

The price-to-earnings ratio (PE) of the market is around 15 or 16, around the long term average. And the ASX 200 is currently yielding about 4.4%, slightly higher than historical averages.

Remember, this is during a time of record low interest rates. So Aussie shares are actually good value right now.

How does this affect LICs?

Well, given LICs pay fully franked dividends, it’s a negative. Remember, in terms of cashflow, this only affects those on the lower tax brackets.

But given the shareholder base is largely everyday investors and retirees who rely on franking refunds, the buy-and-hold style LICs may also fall out of favour.

Others likely to fall in popularity (possibly more-so) are the higher yielding trading style LICs, such as those managed by Wilson Asset Management, for example. Given the higher yield, the franking refund lost is larger.

Essentially, for the older LICs we cover here, it makes them slightly less efficient than before, for low tax paying shareholders.

Let me explain…

A diversified vehicle like Milton invests in a large portfolio of Aussie companies and trusts. And most of those holdings pay fully franked dividends, which are passed onto Milton.

Now, Milton pays no tax on this income because its own tax rate (30%) is the same as the value of those franking credits (30%). So far so good.

But Milton also invests in companies and trusts which don’t pay fully franked dividends, like companies with mostly overseas earnings, utilities, infrastructure assets and property trusts.

Milton has to pay tax on income from these investments. This tax generates franking credits, which it passes on to shareholders with its dividend.

Under Labor’s grand idea, this franking will not be refundable to no/low taxpayers. Although it only affects a small portion of the portfolio, it’s still a frustrating outcome.

How much is it?

Well, for the half-year just ended, Milton earned $71.4m in income and paid just $2.4m in tax. So that’s an overall tax rate of 3.4%.

As you can see, it’s not a lot. But this smidgen of company tax turns a 4.4% yield, into a 4.25% yield for the end shareholder.

Hardly catastrophic, but not ideal either.

Index funds like VAS (Vanguard Australian Shares) operate as a trust structure and don’t pay tax. So any income and capital gains realised are passed straight through to be taxed in the hands of the shareholders.

This structure would be more efficient for low taxpayers under the proposal. More on this later.

Now, LICs may alter the amount of unfranked shares they invest in because of this. We’ll have to wait and see. But essentially, the cash dividend yield is probably more important metric to focus on going forward for retirees, rather than gross yield including franking.

As I said, these vehicles may fall out of favour and begin trading at regular discounts to NTA. This could mean lower prices and a higher yield which would compensate buyers and even itself out to some extent.

Of course, no outcome is certain. But the market may well build this inefficiency into the share price.

Will LICs change to a trust structure?

An idea floating around is that LICs will simply switch to a trust structure (Listed Investment Trust or ‘LIT’), so shareholders don’t lose out.

But it’s not quite that simple. Because there are essentially two types of LICs out there…

One is the old fashioned buy-and-hold LICs like Argo and others, which have been running for north of 60 years and invest for the long term. This means they often have large capital gains built up in the portfolio and are unlikely to liquidate and pay tax to change structure.

And the other is the trading style LICs (like WAM and others) which are more active, higher turnover and generally pay lots of tax on their gains and distribute most of these profits as large dividends. This means there is very little long term capital gains in the portfolio and switching to a trust structure would be rather easy.

Also, shareholders could then have the trading profits distributed in full every year and simply pay tax at their personal tax rate (more efficient for retirees).

While this sounds like a good workaround, the issue for the trading style LICs is, trading profits vary markedly each year, meaning so too will the dividends.

Currently, the company structure allows trading style LICs (and any LIC or company for that matter) to decide a sustainable level of dividends to pay each year, and reinvest the remaining profits, giving them some cushion for next years’ dividend, and so on.

The verdict

So while the old LICs could change to a trust structure, I see it as extremely unlikely. But I could definitely be wrong, so we’ll have to wait and see.

But they know shareholders (mostly retirees) love the consistency of dividends each year and the company structure is what allows this to occur.

One buy-and-hold style LIC which could more easily change to a trust is BKI. At less than 20 years old, BKI is a younger LIC and doesn’t have the large capital gains in the portfolio that the others do.

But I still think it’s unlikely. Whatever decision the LICs make, I believe it’ll be carefully considered and in the best interests of shareholders.

AFIC and BKI have recently decided to pay shareholders a special dividend in advance of possible changes, which get some extra franking credits in the hands of shareholders.

I won’t complain about that! One reader recently said it best, “I’ve never had a special rent payment from any of my tenants before.” Haha, what a great line.

If any of the old LICs do change structure, does that make them less attractive?

In my view, yes… somewhat. For one thing, the trust structure would mean no more smoothing dividends.

But keep in mind, regardless of structure, they are very conscious of providing a growing income stream to shareholders. So investing in good companies which are expected to provide growing dividends would still be the primary focus.

Now I know that isn’t really quantifiable. But personally, that’s very important and definitely counts for something, when we’re comparing these vehicles to an index fund, for example.

LICs and Indexing

There’s no question, this proposal effectively penalises the company structure.

So as detailed above, LICs become slightly less efficient for retirees than an index fund like VAS, for example.

But it’s also very possible that LICs fall out of favour somewhat and trade at a discount to NTA following any changes. Perhaps sizeable discounts.

In any case, the dividend yield of the old LICs and VAS is likely to remain similar. And if we assume LICs continue to operate in the company structure, the dividends will remain more reliable than those from an index fund.

As for the growth outlook, it’s likely similar for both given the diversified portfolios (but tilted in favour of the index, given it won’t miss any big winners).

Thinking this through, let’s say the share prices of the older LICs do fall. This will mean the ‘value’ of your shares has reduced. How do you feel about that?

Keep in mind, this also means you’ll be able to continue buying these investments for a lower price and a higher yield than you otherwise could. How do you feel about it now?

Of course, I’m only speculating here (like everyone else!), but I do think it’s likely to even itself out.

Now, if you’re listening to any hysterical characters in chat forums, you’re likely to think this future scenario could be the end of the world as we know it. Or at least, the end of the world for dividend investors!

Investing for income – is it ruined?

I’ve seen it said that retiring on dividends now doesn’t work as a strategy, and anyone looking to use the income approach or the 4% rule in Australia, is in for a nasty shock. Is that true?

In a word, no!

But let’s look at this in more detail. I’ll show you why it’s not as bad as some would have you believe.

Say an Aussie couple reaches Financial Independence by saving hard and investing in shares, building a portfolio worth $1 million.

Their portfolio has a dividend yield of 4% fully franked, or 5.7% grossed up.

Currently, this means $40,000 of cash dividends, along with $17,000 of franking credits. Gross income is $57,000 in total.

Split between two people this is $28,500 each – $20,000 cash dividends, plus $8,500 of franking credits.

Tax owing on $28,500 is around $2,000 (calculator here). So there are $6,500 of franking credits remaining. These would currently come as a tax refund, taking the after-tax income to $26,500 for each spouse.

This means the total after-tax income for our couple is $53,000. Or an after-tax yield of 5.3%.

Under Labor’s proposal, the franking refunds drop off. So they’ll simply receive the $40,000 cash dividends, and the franking credits will go mostly unused.

So our couple’s income is now just $40,000 in cash dividends. There is no tax to pay because the franking credits count as tax already paid.

Of course, this is a decent cut to income versus the current scenario. But is this couple ruined if they’re relying on 4% dividends?

Nope. 4% of their portfolio is $40,000.

Also, if they’re a sensible, level-headed couple, they would have a number of backup plans in place anyway!

The new numbers

Essentially, the figures for living off fully franked dividends would change. The cash dividends paid is all the income you’d see.

But it’s not all bad.

Cash dividends will still be tax-free up to around $95,000 per person. Here’s why…

Say a person earns $95,000 of fully franked dividends. This will come with roughly $40,000 of franking credits attached.

This gives a gross taxable income of $135,000. But the tax owing on this income is around $40,000, equal to the franking credit. So there’s no out of pocket tax to pay and the franking has been fully utilised.

In case you’re wondering how that works, this is when your income hits an effective tax rate of 30% (some earnings in the lower brackets and some in higher brackets).

Bottom line: our investors will still earn a dividend yield of 4% after-tax.

So a couple can earn up to $190,000 of fully franked dividends and have no out of pocket tax to pay.

This means a portfolio worth $4.75 million, split between a couple, can earn this very hefty income and still clear 4% after-tax. There’s a reason why I say dividend investing in this country is surprisingly tax efficient!

Now this is all great, but it also means those with less wealth still miss out on franking refunds.

So essentially, all of us looking to live on a reasonable sized portfolio would have to accept a 4% or so yield from Aussie shares to fund our Financial Independence.

No longer will the yield be boosted to 5-6%.

Is this as good as before? No.

Is the dividend approach ruined? No.

Is it still better than the alternatives? In my view, yes.

Aussie investing – still worth it?

Firstly, if Labor’s proposal is a deal-breaker for you, then you were investing in Aussie shares for the wrong reasons. You don’t base an investment strategy on one piece of tax policy.

Some people have pointed out that if these changes come through, it might be better to focus investing internationally.

Maybe that’s the right choice for many people, and you can most certainly do that. But it’s not for me. At least not yet.

Like I’ve said previously, I’ll look at investing in international shares once our Aussie income stream is fully built.

But right now, given we’re investing for an income stream to live on, it doesn’t make sense for us. Here’s why…

Investing in an international index fund like VGS (Vanguard International), we can generate an income stream with a yield of 2% to 2.5%. That’s before tax. And normal tax brackets apply.

Investing in an Australian index fund like VAS (Vanguard Australia), we can generate an income stream with a yield of 4% to 4.5% yield. That’s after tax. And high levels of franking credits will mean no tax payable until our income is well into the six-figures.

So the starting yield from international shares is about half. And it’s less tax efficient. Plus, the currency movements mean those dividends will fluctuate a lot from year to year. That’s compared to Australian shares which pay dividends based in Aussie dollars.

Now of course, you can argue that international shares are more about growth. I understand that. And that’s why as income investors who don’t wish to sell off shares to create cashflow, Aussie shares make more sense for us.

Banking on higher growth and selling off shares is just not something I’m comfortable with. But you do what’s best for you!

Investment Strategy

It’s easy to get caught up in comparisons and numbers. So let’s bring it back to basics for a minute.

Our approach is to invest in a diversified portfolio of Australian shares for a strong level of tax-effective dividend income, which grows over time.

As our economy and population expands and company profits grow, corporate Australia will pay larger dividends to shareholders through the years.

Aussie companies have been paying dividends of around 4-5% per annum for the last 100 years – way before franking credits even existed, let alone franking refunds.

So I don’t see why either of these things would stop now.

And I don’t know about you, but 4% after-tax yield for a reliable, hassle-free, diversified income stream is good enough for me.

Add some growth in line with the economy (3-4%), and you’ve got a pretty attractive long term return. Not to mention an income stream that is most likely to beat inflation and keep us well fed in our early retirement!

Why LICs will be fine

Following on from the above, a number of the old LICs have been around since the 30s, 40s and 50s.

Again, this is well before the imputation system was even thought of, let alone franking refunds!

For example, Milton has been providing growing dividends to shareholders since 1958, which have increased comfortably faster than inflation. Argo and AFIC have been prospering even longer than that.

Through changes in tax policy. Changes in government. And changes in the economy.

And I believe they’ll continue prospering for a long time to come.

Why? Because they get the basics right.

They’re conservatively managed. They focus on keeping costs low. And they invest in a diverse group of profitable businesses for the long term. Most of all, their focus is on the fundamentals – the earnings and dividend streams.

These factors are just as important as ever. Perhaps even more so today, in a world of hyper-trading, growth chasing and the get rich quick mentality.

How to deal with the possible franking changes

As I see it, there are 4 ways you can approach this…

–1. Stop investing until there is more certainty. Or as the market-timers call it, “wait until the storm passes.” Unfortunately, there are never certainties in investing. Only probabilities.

After this ‘storm’ goes away, there’ll be another one. Then another one!

I get this makes people nervous, but the fact is we have to keep investing anyway. By breaking our investment habit, we’re essentially saying that news and short-term political issues are more worthy of our focus than our long term plans. Rubbish!

If that’s enough to frighten us off, then how on earth will we ever invest when we have a recession one day?!

–2. LIC investors can decide to buy index funds like VAS, until after the changes come through, to see what affect it has on LICs.

Then make a decision which option looks more attractive going forward. This is a more reasonable thing to do than the above!

–3. Continue along with your chosen investment strategy and ignore it all. Now, this may seem reckless to some, but it’s a very valid choice. There’ll always be changes coming out of left field.

If you’re happy with your strategy and still expect to comfortably reach your goals, that’s all that matters.

–4. Look for ways to tweak your strategy, to optimise use of franking credits and low tax rates. See next section.

Notice that freaking out and jumping ship isn’t an option? That’s because we don’t do that around here, as it makes zero sense.

After all, the dividend approach is still valid. Investing in Australia still makes sense. And the income stream is still very attractive.

Adjusting the portfolio

For those in the accumulation phase, there will likely be no noticeable difference in your investment returns.

So this section is more for the soon-to-be retirees or those already financially independent. But it’s still worth thinking about what you’d do in the same scenario.

There’s an infinite number of ways you could rejig your portfolio – many depend on your own situation.

This isn’t an exhaustive list. But here’s a few options I see for Aussie income investors on low tax rates, if they do see their after-tax cashflow reduced by Labor’s changes.

— 1. Buy Aussie index funds instead. This will ensure that zero tax is paid by the fund (as discussed above with LICs). Dividends will be more lumpy through the cycle, so a larger cash buffer will be required.

— 2. Buy REITs (real estate investment trusts). These also pass through almost all cash earnings and so very little tax is paid by the trust. For zero/low taxpayers like us, the high yields can be attractive. Generally not well suited to high taxpayers.

Be very careful, as not all REITs are good. Many trade at low yields currently, and many others have poor dividend histories.

We do own a few REITs today, including AQR, AVN and CMA (not advice). I may do a post about REITs in the future, if readers are keen (let me know).

There’s also ETFs like this one (thanks to ‘Nodrog’ for finding it). The fund aims to hold a group of higher yielding and diverse ‘Real Assets’ (think REITs, utilities and infrastructure assets). All holdings are ‘trusts’, so income is passed through to the shareholder. The fee seems high, but it looks okay at first glance.

— 3. Peer-to-peer lending. Again a high yielding option which could suit those on low tax rates. We’ve been using RateSetter as a small part of our portfolio for a few years now. I like it for a few reasons…

High yield monthly interest payments. Different time-frames to choose from. A healthy provision fund in place, helping no lender to lose a cent since beginning in 2010. It’s possible to start with very small amounts, the platform is easy to use and has good transparency of data.

If you’re interested, read my full overview of peer-to-peer lending and RateSetter (there’s also a $100 signup bonus for Strong Money readers!).

Things to remember

If choosing some of the higher yield options above, keep them as a smaller part of your portfolio.

And remember, tweaking your portfolio at all is 100% optional.

Also, be careful when looking to juice your income/yield in the short term. It can leave you worse off in the long run. Or, as they say, there’s no free lunch!

While it’s fine (I think) to give consideration to higher yielding options, we absolutely need growth to keep our income rising with inflation. So chasing yield and ignoring growth is a bad idea.

A little bit of extra yield is okay. But don’t get greedy, or you’ll be left with a high risk portfolio which has poor or no growth over time.

What am I doing?

After all this chatter about what it means and what you can do about it, what are we actually doing?

Well, not much to be honest!

I’m continuing to buy shares every month. Yes, even in LICs. But generally, I’m less willing to buy when prices are above NTA. So in that case, I sometimes look to buy the index instead (VAS).

I do find Aussie index funds more attractive than a couple of years ago, for a few reasons which I’ll get to in another post.

But our share portfolio is still mostly LICs, and gladly so. On top of this, we hold a few REITs and have some funds in RateSetter.

And in case you think I’m being reactive, both were a part of our portfolio before Labor’s grand plan came to light.

So nothing has really changed!

But I’ll be interested to see if LICs take a hit should this policy come through, as it might offer some attractive buying opportunities.

Maybe it’s already starting to be priced in, as Milton and BKI are both currently trading at a discount to NTA of around 5%.

Summary

It might seem like I don’t care about what happens. But that’s not really true. In fact, we’re a good example of those who’ll be hit the hardest.

I just believe we’ll always find a way to make it work. Because if there’s one thing we can be sure of, it’s that unexpected things will happen.

Policies will change. Governments will change. Markets will change. And you can bet the economy will change.

In my backup plans series, I laboured the point of building resilience and being adaptable. And the possible franking changes are a perfect example of why that’s so important.

Those who get overly emotional about this stuff are bound to make poor decisions and lose sight of the big picture. Yes it’s important, so naturally we care. But it’s more important to make sensible long term choices that align with our goals.

Final Thoughts

Bottom line: Suck it up. Don’t panic. We’ll survive.

You might’ve noticed something throughout this blog. We’re not just building financial strength here. We’re building personal strength as well.

Because that’s just as important in reaching our goals and living a great life.

We need to focus on our own actions and what we can control. What does this mean exactly?

Keep your living costs in check. Save as much as you can. And stick to a regular investment plan, no matter what.

As always, stay focused on constantly increasing your ownership in a large group of Australian businesses to hold for the long term, and measure your results by the ever growing income stream!

Do you plan to change anything about your investment strategy if the franking changes come through? Let me know in the comments.

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