Using gearing to diversify wealth outside of superannuation, and the power of franking credits

A long term goal of many investors is to build wealth outside of superannuation to supplement and diversify their income in retirement. Or they may want to build a portfolio which ultimately provides a source of funds for expenses or purchases requiring a larger amount of funds.
Gearing can potentially accelerate this objective. It gives the borrower access to additional funds to invest, and potential tax deductions in their income earning years.

What is gearing?

Gearing simply means borrowing money to invest. You can borrow to invest in a range of financial assets like shares, managed funds or exchange traded funds (ETF’s). Ideally over the long term the capital growth achieved in your portfolio outweighs the cost of the loan and allows you to grow your portfolio faster using the benefit of compounding returns.

Gearing can magnify both gains and losses. It is important to understand the risks. If used carefully especially with a long-term investment horizon, it can significantly enhance your investment growth.

Why use gearing and not just build wealth within superannuation?

Superannuation is considered tax-effective due to tax concessions. These can be in both accumulation and pension phases. It does have limitations though, the most common being restricted access to funds until meeting conditions of release.

A geared investment portfolio held outside of super offers several benefits:

1. Liquidity and access to funds
   Investments outside super can be sold at any time. You are able to access your funds when you need them.
2. Tax Effectiveness
   Interest on investment loans is typically tax-deductible in the year in which it is incurred. This can help reduce your overall taxable income. Especially if you are in a higher tax bracket. This depends on an individual own circumstances.*
3. Diversification
   It allows you to diversify your wealth creation strategies beyond property and superannuation. Potentially accessing a broader range of investment opportunities.
4. Wealth Acceleration
   By investing more than your own capital and using borrowed funds, you potentially accelerate the compounding effect of returns over time. Assuming positive performance of equity markets.
   
   
   

Risks and considerations

While gearing can be powerful, risks need to be considered:

• Gearing can magnify gains as well as losses.
• Events such as margin calls, market disruptions, credit limit exceeds, default events or termination can result in some or all of the loan being due for payment. Often in a short period or immediately.
• Loan commitments: You must continue repaying the loan, even if the investment underperforms.
• Interest Rate Risk: Rising rates can increase costs and reduce net returns.

The power of franking credits.

If you’re investing in Australian shares, franking credits can play a key role when building an income stream. Particularly later in life.
Franking credits are tax credits attached to dividends paid by Australian companies, as the company would have already paid corporate tax. When you receive these dividends, you may also receive the franking credits, depending on meeting the eligibility criteria. This may be used to offset your personal tax.

The power of franking of credits is summarised below:

1. Boost After-Tax Returns
   Franking credits can enhance the after-tax return of your investment. For example, if a fully franked dividend is 4%, the grossed-up return including the franking credit it might be closer to 5.7%. That could result in an increase in your returns, especially over time.
2. Offset Interest Costs
   While you will pay interest on your geared investment, franking credits can help offset this by lowering your effective tax bill. In some cases, franking credits can even result in a tax refund. Especially if your marginal tax rate is lower than the company tax rate (typically 30%).
3. Tax-Efficient Income
   In retirement or semi-retirement when your income is lower, franking credits can provide an additional tax effective source of income. In retirement this might complement income that is paid as an allocated pension.

Additionally, in retirement or pension phase investors are required to draw a minimum amount of their super account per year. With a portfolio held outside super, there is no requirement to take any funds if you do not require it.

Conclusion

Gearing outside of superannuation offers a strategic way to help build wealth. Especially for those who want flexibility and access to their funds. When combined with fully franked dividends, it can become a tax-effective strategy. Over time, income from investments and franking credits can provide a tax effective way to help cover ongoing expenses.

If you’re ready to start building wealth through gearing, we’re here to help. Call us today to speak with a customer service consultant to find out how to get started.

If you are financial adviser and want to learn more about recommending gearing to your clients, contact one of our Business Development Managers.