Franking credit changes would box-in the vulnerable

How’d you feel if you worked your entire life towards a goal, only for the posts to be shifted backwards — after you’ve finished your race?

I really don’t want to get political, but the proposed rule changes by the federal opposition in Australia to are fundamentally unfair to the those already in retirement.

My core disagreement with the policy is that in many cases those worst impacted would be people who have no opportunity to defend their financial futures, due to their age and circumstances brought about by time.

The proposed changes

For those that don’t know, franking credits are a portion of tax already paid for a shareholder on behalf of the company — up to a rate of 30%.

Franking credits were created to remove being double taxed. Eg: You own shares in a company, who makes a profit that is then taxed. The remaining profits are distributed as a dividend — income that you as an individual would otherwise be taxed on again as personal income. Enter franking credits. It’s a pretty a fair solution.

These franking credits then get funded come tax time, assuming you don’t earn enough money through other income. Many retirees in Australia rely on these refunded tax credits as assumed income — it’s been a legislated policy for almost 20 years.

The opposition has pledged to remove any tax refunds on surplus franking credits to save money. It would save them billions of dollars. I can understand why they would want to do it.

But the problem is that it hits the people who deserve these changes the least, and they wouldn’t be able to respond and change their fates.

Impacts of changes

If you had millions of dollars of shares (or other income from investments), you’d likely be fine. You’d probably earn enough through dividends to have a large enough income to not be affected by a progressive 30% tax rate. So, sadly, it’ll be smaller shareholders, rather than the wealthy, who will be impacted.

Here’s a very useful analysis by terrific blogger Aussie HIFIRE on how the changes would effect people looking to retire early and who have significant exposure to imputation credits.

Those who are still working won’t be impacted unless they are on very low wages.

Instead, my biggest fear is for those retirees who are beyond normal working age. They will have their income cut — some by many thousands of dollars — through no fault of their own.

They would essentially be punished for doing the right thing (eg: working within the rules of the day). They are self-funded retirees who actually reduce the welfare burden on the government by not needing a pension.

I can understand wanting to be egalitarian, and making the poorer wealthier, or wealthy poorer.

But this would just widen the inequity gap. The poor get poorer, the wealthy stay wealthy. It doesn’t seem like a very Labor thing to do.

Impact on us? None. However, the impact on older retirees… Wow.

These changes, should they come into effect, would have a minimal effect on Ellie and I. Currently our incomes are too high to get refunds. And in the future we’re looking to have a retirement income of around $150,000 (including franking credits), but part of that — some $30,000 — will be un-taxed rental income, plus some dividends that don’t have any franking credits attached to them.

Any impacts could be worked around by changing our income mix. Eg: more shares in companies that don’t distribute franking credits in their dividends, or a pivot towards another investment property or two, etc.

So that’s not what really worries me. We’ll be fine (but thanks for your concern!).

Instead, I’m saddened and worried about the people who aren’t in a position to react to these changes. They’re beyond working age and can’t earn more money. Someone who was 60 when these existing laws came into effect would be almost 80 now. What are they going to do to earn more money?

Their only option would be to change their asset mix.

But this is where I feel the real kicker is… (If there has been any discussion on this in the media or online, I haven’t seen it. Apologies if I’m covering old ground here.)

They might also effectively have stranded assets, and are unable to react by changing their mix of shares.

Capital Gains Tax

By stranded assets I mean they may have bought shares years ago that are worth a lot more now than they were.

Great news, right? Mmm, not really.

That means they’d need to pay Capital Gains Tax (CGT). And unless I’m way off the mark, that would be a huge problem for retired shareholders.

As a very real example, Commonwealth Bank ($CBA) shares are a market darling for retirees because of their high dividends and full franking credits. 20 years ago were worth about $23. They’re now $71.

They’d be hit with CGT on their $52 a share profit if they tried to sell these shares.

Or how about this one? CSL ($CSL) shares were trading for for a steal 20 years ago for under $5. They’re trading at $184 a pop now. What would normally be a share growth success story will go back to haunt you when it comes time to pay CGT on a $179/share profit.

So you’re damned if you do, damned if you don’t.

You physically can’t earn more money because you could be 85 years old now. You can’t change your asset mix either because you would severely erode your capital base due to tax being applied to your profits.

If you had a long-held portfolio with shares like those above, and you sold a significant amount to reinvest in other assets, you’d likely be out tens of thousands of dollars — which you then can’t reinvest. Your income drops one way or another.

It’s a nasty, cruel situation.

What could happen in the future?

Like I said earlier, for us, these changes — if they ever occur — would be fine. We’d only be slightly affected at most to begin with, and we could work around it by changing our asset mix.

However, what does worry me about us is that similar changes may happen to us a few years into our own retirement and significantly hit our incomes. Tax on investment income could be applied differently to wage income, or tax scales are altered again in a disadvantageous way. That could have a huge impact.

If we’re still young enough when it happened, we could go back to work part time if such changes hit us hard enough. But that would only be possible when we’d still be fairly young — I can’t see myself stacking shelves as an 80-year-old.

But worst case scenario: we’re too old, and we’ll suffer in the same way as people would from these proposed changes.

That’s the exact reason why we are looking to have a large retirement income. We don’t want to go from “FatFIRE” (a large income and expenses) to “LeanFIRE” (smaller income, smaller expenses) involuntarily down the track.

Changes to policy will come and go over time, but the higher our income to start with, the greater our capacity to absorb any impacts. We’re happy to work an extra year or two to try to ensure the remaining 40–50 years of our lives will be financially stress-free.

An easy fix

So like we’ve discussed, this is a flawed policy, that targets the wrong people. Assuming the policy goes ahead, I have one small change to make it fair. The easy solution — for this change, and the inevitable ones in the future — is one they are looking to implement for another change in law.

As part of the changes the opposition want to bring in, they want to halve the CGT discount from 50% for assets held for more than a year, to 25%. That’s due to low inflation in recent years, and it makes sense in many ways.

But these changes would be grandfathered. They won’t impact any CGT events except from the day they are enacted. In other words, they want to grandfather the existing CGT policy.

That is exactly what should happen to franking credit changes. Eg: continue to enforce the same tax rules on existing assets.

For everyone else still working, they can work, plan and react accordingly to the new rules.

That way, vulnerable people who worked years — even decades — towards a goal won’t be punished for doing the right thing, and planning for their futures in accordance with the rules of the day.

Cheers,

Alex

Originally published at hishermoneyguide.com on February 22, 2019.

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We’re Alex & Ellie, a 30-something married couple who started HisHerMoneyGuide to highlight how you can join us and reach financial independence sooner.

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Alex Ellie

We’re Alex & Ellie, a 30-something married couple who started HisHerMoneyGuide to highlight how you can join us and reach financial independence sooner.