In my post about the 4% rule I highlighted that the studies it is based on do not take into consideration taxes. Taxes are an important factor when determining portfolio size requirements as they can consume a considerable chunk of your household pre-tax income, in the case of retirement, portfolio distributions. This leaves you with less post-tax income to meet your cost of living which will result in higher portfolio requirements than what the 4% rule suggests. To assist with this consideration, I’ve calculated the pre-tax income for a variety of post-tax income levels for single and 2-person households. The assumptions for the calculations are as follows:
- All distributions are unfranked
- For the 2-person household, the portfolio distributions are taken at a 50/50 split
- Portfolio distributions are the only source of income
- The portfolio distribution rate is 4%
- Calculations include the 2% Medicare levy
- Individuals earning less than $22,800 are exempt from the Medicare levy
- All members of the households have private health insurance so they are not subject to the Medicare levy surcharge
- All members of the households are full time Australian residents
- Taxes are calculated at the individual income tax rates for the 2020-2021 financial year and are displayed in the table below:
- Calculations do not include the Low Income Tax Offset and/or the Low and Middle Income Tax Offset
| Taxable income | Tax on this income |
| 0 – $18,200 | Nil |
| $18,001 – $45,000 | 19c for each $1 over $18,200 |
| $45,001 – $120,000 | $5,092 plus 32.5c for each $1 over $45,000 |
| $120,001 – $180,000 | $29,467 plus 37c for each $1 over $120,000 |
| $180,001 and over | $51,667 plus 45c for each $1 over $180,000 |
The following tables show the pre-tax income, tax liability, average tax rate and portfolio size requirements for single and 2-person households for varying post-tax income levels:
Observations
As we can see from the tables above taxation does consume a considerable proportion of pre-tax income. For example, in the case of the single person household, if they have a cost of living of $40,000 p.a. the 4% rule typically implies that they require a portfolio of $1,000,000. However, when tax is taken into consideration, they will actually require $46,515 of pre-tax income to generate their required post-tax income. This puts their portfolio requirements at $1,162,863, which is a 3.44% withdrawal rate. Because of our progressive tax system this effect is more pronounced as required income rises into the higher tax brackets. For example, if a single person’s yearly cost of living is $100,000, they will need about $139,454 in pre-tax distributions and a $3,486,352 portfolio. This equates to 2.87% withdrawal rate.
The 2-person household advantage
Because the members of the 2-person household own the portfolio 50/50, individual tax liabilities are based on half of the household’s overall pre-tax income. This significantly reduces the household’s total taxation. Using the $40,000 p.a. cost of living example again; each person in the household will need to earn about $20,422 p.a. each, which puts both people at the bottom of the 19% tax bracket as opposed to near the top. As a result, they only need to pay $422 tax each ($844 total) compared with $6,515 for a single person household. As a result, their portfolio needs are $1,021,111 which is close to $141,751 less than the single person household. An observation is that at these income level requirements, the 4% rule is very accurate.
Referring again to the $100,000 cost of living scenario, we see that the 2-person household needs a $3,089,084 portfolio to generate this after-tax income, which is $397,268 less than what a single person household would require.
Methods to reduce taxation
Franked distributions
Franking credits require a separate post to discuss in more detail, however the general idea is that if you own shares in a company the has franked distributions, the company pays tax at its tax rate of 30% on your distributions, so you will be entitled to a franking credit if your marginal tax rate is lower than 30%. This effectively increases the yield of your shares.
Selling assets to fund income requirements
This one can be a difficult to overcome emotionally as it will reduce the number of units you own over time. However, selling fund units means they are subject to capital gains tax rules. This means that you are only taxed on the profit that is made from selling the units and if you’ve held the units for longer than 12 months this rate is halved.
Discretionary trusts
Discretionary trusts allow the trustee to divide the distributions between multiple beneficiaries of working age. This reduces the size of the distributions and lowers the marginal tax rate. The benefits are similar to that of a 2-person household vs a single-person household. Discretionary trusts allow the trustee to distribute assets between beneficiaries according to their tax brackets so the beneficiaries in the lowest tax brackets can be apportioned with more assets for greater tax efficiency. There are costs and legal implications associated with using trust structures so please speak to a tax professional or financial advisor to get the full picture.
Allocating ownership of assets
The 2-person household example that I’ve provided in this post has been for a 50/50 split in ownership of portfolio assets where both parties do not earn an income. If the members of the household are on different incomes, then it can make sense for the ownership of the assets to be weighted more towards the member of the household with the lower income. This is can be done using a discretionary trust, as discussed previously, or done through the transfer of assets. If assets are transferred, it is important to remember that capital gains tax will be applied if the purchase price is less than the price at the time of the transfer.
Private health insurance for higher incomes
If your distributions are going to be higher than the threshold for the Medicare levy surcharge ($90,000 for singles and $180,000 for families (ATO 2020)), it may be more cost effective to keep your private health insurance.
Control your cost of living
The tables above show that the 4% rule becomes less useful as required income increases. So, households that can keep their spending at levels where taxation is lower will benefit substantially by requiring substantially smaller portfolios. To re-iterate the point in another way, because the rate of taxation increases as income increases, portfolio requirements go from $25 per $1 required income (4% withdrawal rate) to over $35.20 per $1 required income (2.84% withdrawal rate).
Superannuation
If you are over 60 years old, superannuation distributions are not taxed. This makes superannuation a tax efficient vehicle for holding retirement assets and generating retirement income. The major downside is that you need to be over 60 years old to access it, and by the time I’m 60 I believe that this age requirement will increase.
Concluding thoughts
Because of the way that Australia’s progressive tax system increases marginal tax rates as income rises; portfolio requirements for retirees increase materially as required income levels rise. This is especially evident as income requirements increase through the tax brackets. When setting your own portfolio requirement goals, it’s important to consider the effect of taxation your anticipated income distribution streams and household situation.
Engineer your freedom
References
ATO, 2020, Individual income tax rates, ATO, available from: <https://www.ato.gov.au/rates/individual-income-tax-rates/>
ATO, 2020, Medicare levy, ATO, available from:
<https://www.ato.gov.au/Individuals/Medicare-levy/>
ATO, 2020, Medicare levy exemption, ATO, available from: <https://www.ato.gov.au/individuals/medicare-levy/medicare-levy-exemption/>
ATO, 2020, Medicare levy surcharge, ATO, available from:
<https://www.ato.gov.au/individuals/medicare-levy/medicare-levy-surcharge/>