Tax on my hard-earned money…. Ewww!
Having to pay tax during retirement means your investments will need to earn a rate of return sufficient to cover both your cost of living and taxes. It goes without saying that structuring your investments and income streams to reduce taxation should be an important consideration for those looking to self-fund an early retirement.
Australian taxation system for individuals
In general, for individuals, taxable income is calculated by adding all of your income streams and subtracting tax deductible expenses. The appropriate level of taxation is then applied depending on which bracket your taxable income falls within. For the 2021-2022 financial year tax rates can be summarized in the following table:
| Taxable income | Tax on this income |
| 0 – $18,200 | $0 |
| $18,201 to $45,000 | 19% of $1 over $18,200 |
| $45,001 to $120,000 | $5,092 plus 32.5% of $1 over $45,000 |
| $120,001 to $180,000 | $29,467 plus 37% of $1 over $120,000 |
| $180,001 and over | $51,667 plus 45% of $1 over $180,000 |
In addition to this, if a single person’s income is greater than $23,226 ($36,705 for seniors and pensioners entitled to the seniors and pensioners tax offset), they will need to pay an additional 2% Medicare levy on their taxable income (ATO 2021)
Tax free threshold
What we can take from table 1 is reducing individual taxation, legally, is all about reducing taxable income. If an individual’s taxable income is less than or equal to $18,200 then they are free from any tax burden. For couples that file one tax return each this number essentially doubles to $36,402.
Income streams
Rent
Any rental or rental-related cash-flows are considered as income (ATO, 2021). This means a single person can only collect up to $18,200 of rent before being subject to income tax. This makes rent a tax inefficient income source when compared with franked dividends and sale of portfolio units.
Franked dividends
As discussed in a previous article, in Australia, the dividend imputation tax rules allow shareholders to avoid paying income tax on the proportion of distributions that the company has already paid company tax on. Taxation is calculated based on the grossed-up dividend yield and franking credits are paid to shareholder to make up the difference if their income tax liability is less than the company tax rate. This means that as long as the franking credit is sufficient to cover their tax bill an individual can have a franked dividend income greater $18,200 and avoid paying income tax. They will, however, still be subject to the Medicare levy if their income is greater than $23,226.
For example, if an individual owned $1,328,000 worth of Australian Foundation Investment Company (AFI.AX) stock which has a dividend yield of 2.87% (ASX 2021) their taxation situation would look something like this:
| Dividend received (2.87%) | $38,114 |
| Imputation credit | $16,334 |
| Grossed up dividend (Taxable income) | $54,448 |
| Gross tax payable | $8,163 |
| Franking credit | $8,172 |
| Take home | $38,123 |
In this example the value of their franking credits ($8,172) is greater than their gross tax payable ($8,163) so the shareholder has no tax liability. Essentially, if the company tax rate is 30%; dividends are fully franked; and we are using the 2021-2022 individual income tax rates an investor can collect up to ~$38,000 in dividends tax free. This makes fully franked dividends a tax efficient retirement income stream. However, in this example, the investor is, still liable for the 2% Medicare levy on their taxable income.
Sale of portfolio units
When looking to fund retirement, income streams like rent and franked dividends are discussed often, however, selling portfolio units tends to take a back seat. This is because people think that if they gradually reduce their holdings over time, they will be eventually left with nothing. Now this is only true if their value of the fund units is very large compared to their cost of living; e.g., a $1M dollar portfolio consisting of 2 investment properties. Even then, it’s possible to sell one unit and purchase more units of assets of smaller denomination.
If an investor sells their assets for a profit, they must declare a capital gain. The capital gains tax liability depends on the profit made on the sale of and whether or not the asset was held for more than 12 months. In the case of a share portfolio with multiple different purchase points, the weighted average cost of capital is used (WACC). For example, if an investor purchased 3,000 units of VGS.AX ETF’s every year on the 1st of January for 5 years starting in 2016 their portfolio building journey would look like this:
| Date | Units purchased | Price | Value |
| 1/01/2016 | 3,000 | $54.77 | $164,310.00 |
| 1/01/2017 | 3,000 | $58.14 | $174,420.00 |
| 1/01/2018 | 3,000 | $67.09 | $201,270.00 |
| 1/01/2019 | 3,000 | $67.48 | $202,440.00 |
| 1/01/2020 | 3,000 | $85.49 | $256,470.00 |
| Totals | 15000 | $998,910.00 | |
| WACC | $66.59 |
Now, if the investor is looking to fund their living costs of $50,000 for 2021, given the ETF price of $83.86 as at the 1/2/2021, they would need to sell 597 units to fund their cost of living. Given their WACC of $66.59 the cost of sale is $39,756.62 which makes the profit (capital gain) of the transaction $10,307.80. Since the last purchase was made over 1 year ago, they can declare a capital gain of ($10,307.80/2 = $5,123.90). Assuming that this is their only income source their taxable income will be $5,123.90 which is well under the $18,200 tax free and $22,226 Medicare levy thresholds. The details of this transaction are shown in table 4
| Sale at 1/02/2021 | |
| Sale price | $83.86 |
| cost of living | $50,000.00 |
| units to sell | 597 |
| Sale price | $50,064.42 |
| Cost of sale | $39,756.62 |
| Profit | $10,307.80 |
| Taxable income | $5,153.90 |
When selling portfolio units, if the assets have been held for more than 1 year then an investor simply needs make less than $18,200 x 2 = $36,400 profit to avoid paying income tax. Extending this to the previous example, because the WACC is quite high relative to the sale price the investor could have funded a $170,000 cost of living and still avoid paying any income tax. Having said that, they would need a portfolio of over $4.25M to have any hope of sustaining this long term and they would be liable for the Medicare levy. This example shows how tax efficient selling portfolio units to fund retirement is.
Concluding thoughts
Assuming that your WACC relative to the current market price isn’t ridiculously low then selling your fund units is likely to provide the highest tax-free income level in retirement. How high your cost of living can be before being subject to taxation depends on your portfolio’s WACC vs the price that the units are liquidated at. The higher the WACC relative to the sale price, the lower the capitals gains; and the lower the tax payable. Remember that holding the units for greater than 1 year will halve the reported capital gains.
As I have said before, taxation considerations should always be secondary to portfolio growth. So, do not try to increase your WACC purely for the sake of decreasing taxation as this will likely blunt your portfolio returns.
Engineer your freedom
References
ATO, 2021, Individual income tax rates, Australian Taxation Office, available from: <https://www.ato.gov.au/rates/individual-income-tax-rates/>
ATO, 2021, Medicare Levy, available from: <https://www.ato.gov.au/Individuals/Medicare-and-private-health-insurance/Medicare-levy/>
ATO, 2021, Rental income, Australian Taxation Office, available from: <https://www.ato.gov.au/Forms/Rental-properties-2021/?page=4>
ATO, 2021, Capital gains tax, Australian Taxation Office, available from: <https://www.ato.gov.au/Individuals/Capital-gains-tax/>
ASX, 2021, AUSTRALIAN FOUNDATION INVESTMENT COMPANY LIMITED AFI, ASX, available from: <https://www2.asx.com.au/markets/company/afi>
Yahoo finance 2021, Vanguard MSCI Index International Shares ETF (VGS.AX) 30/12/2015 to 31/12/2021 (Monthly), Yahoo finance, available from: <https://au.finance.yahoo.com/quote/VGS.AX/history?period1=1451433600&period2=1640908800&interval=1mo&filter=history&frequency=1mo&includeAdjustedClose=true>