Taxation is an important factor to consider when you’re using your portfolio as a source of income. There are a number of ways to fund your retirement this such as taking dividends, bank interest or sale of investment units. Each will attract a different level of taxation depending on your unique situation. In this post I’d like to explore the tax treatment of these options:
Bank interest
When interest rates were higher, using a term deposit was a very popular way for retirees to fund their retirement. I remember the early 2000s when term deposits would attract interest rates in excess of 5%. For a portfolio of $1M you could have $50,000 of risk free, pre-tax income which, for many, was a very healthy retirement income. Ah the good old days. The price of this however, is the inefficient tax treatment of bank interest. In this example portfolio the full $50,000 of interest would be subject to taxation, so for a non-working single person in the 2019-2020 income year this will attract $7,797.00, excluding the 2% Medicare levy (ATO 2020).
Sale of investment fund units
In Australia, capital gains tax is triggered when you make a capital gain on the sale of your assets (ATO 2018). For example, if you purchased 25,000 shares for $1 and sold them for $3 your capital gain would be 25,000 x ($3 – $1) = $50,000. If you held the shares for less than 1 year you would attract the same level of taxation ($7,797.00) as the previous example. However, if you held the shares for more than 1 year you would be eligible for a 50% capital gains tax discount (ATO 2020) which would reduce your taxation to $3,898.50.
Weighted average cost of capital (WACC)
If you have completed multiple purchases of the same investment at different prices, capital gains tax is calculated based on the weighted average cost of capital. Let’s look at the following example:
| Purchase price | Units purchased | Cost of purchase (Purchase price x Units Purchased) | WACC |
| $50.00 | 1000 | $50,000.00 | |
| $60.00 | 1000 | $60,000.00 | |
| $30.00 | 1500 | $45,000.00 | |
| Total cost | 3500 | $155,000.00 | $44.29 |
Because WACC is calculated by:
it will tend to be lower than the standard average price in dollar cost averaged portfolios. This is due to the fact when dollar cost averaging, investors will tend to automatically purchase more units when value of the investment units falls. Continuing on with this example let’s look at the taxation situation if the assets were held for more than 1 year and part of the holding was liquidated.
| Current price | $70.00 |
| WACC | $44.29 |
| Units sold | 714 |
| Total proceeds | $49,980.00 |
| Capital gains | $18,360.00 |
| 50% discount | $9,180.00 |
| Tax | $0 |
Here we see that since the capital gains (after 50% discount) is below the tax-free threshold we can avoid taxation entirely while still generating a similar amount of income to the bank interest example.
Franked dividends
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. This means that the grossed-up yield of a company tends to be higher than the standard distribution rate listed on the ASX. Using the Australian Foundation Investment Company (AFI.AX) as an example we see that the dividend yield, as at 15/5/2021, is 3.21% (ASX 2021). Using the formula:
We obtain a grossed-up dividend rate of:
For an investor with no other sources of income and a $1,000,000 AFI.AX holding, their take home income after tax will be $39,406.62 (Note 1) as per the table below.
| Dividend received | $32,100.00 |
| Imputation credit | $13,757.14 |
| Taxable income | $45,857.14 |
| Gross tax payable (ATO 2021) | $6,450.52 |
| Franking credit (tax refund) | $7,306.62 |
| Take home | $39,406.62 |
Essentially, the investor will receive $32,100 worth of dividends during the financial year, however their taxable income is based on the grossed-up dividend ($45,857.14). The imputation credit ($13,757.14) represents the tax paid by the company, of which only $6,450.52 is owed to the tax department by the investor, which means that the investor will receive $7,306.62 worth of franking credits with their tax return.
Because franking credits are designed to eliminate double taxation, franked dividends are more beneficial to those with marginal tax rates that are lower than the company tax rate (30% for most companies). Individuals with marginal tax rates greater than 30% will often be required to pay tax on their dividends to make up the shortfall between their marginal tax rate and the company tax rate.
Comparing the 3 methods
Of the 3 methods discussed here, selling a portion of your portfolio to fund your retirement is the most tax efficient method for producing a retirement income stream. This is because investors are only taxed on their capital gains (sale price – WACC) and given a 50% discount if the assets have been held for more than 1 year. The second most tax effective income stream is fully franked dividends. However, where this option falls short is that it does not give any concession to the purchase price of the asset. In the dividend example that I provided the taxation level would be the same regardless of whether that $1M portfolio had a WACC of $500,000 or $2M.
Even though selling portfolio units is the most tax effective method, especially at higher income levels, it may not always be appropriate as an income stream. If your portfolio is comprised of only a small number of high value units that grossly exceed your yearly income requirements then selling them for income presents some non-tax related issues. For example, selling a $500,000 investment property to fund your $50,000 yearly cost of living means that you forgo the possibility of asset price appreciation for numerous years. There is also the question about what to do with the excess cash. Also, if your assets are highly illiquid, difficult to value or highly volatile it can be difficult to obtain the necessary amount of cash in a timely manner to fund your cost of living.
Singles vs couples
As I’ve touched on before, couples have a tax advantage over singles when funding retirement. This is because the income can be split across two people which attracts disproportionately lower taxation. This can be further extended to discretionary trusts where portfolio income can be split between even more people. Trusts are more complex so please speak to your accountant or financial advisor to find out if it is the right arrangement for you.
Engineer your freedom
References
ATO, 2020, Capital Gains Tax, Australian Taxation Office, available from: <https://www.ato.gov.au/general/capital-gains-tax/>
ATO, 2018, Working out your capital gain or loss, Australian Taxation Office, available from: <https://www.ato.gov.au/General/Capital-gains-tax/Working-out-your-capital-gain-or-loss/>
ATO, 2020, Simple tax calculator, Australian Taxation Office, available from: <https://www.ato.gov.au/calculators-and-tools/simple-tax-calculator/>
ASX, 2021, AUSTRALIAN FOUNDATION INVESTMENT COMPANY LIMITED AFI, ASX, available from: <https://www2.asx.com.au/markets/company/afi>
H&R Block, 2019, Tax and Dividends: How Your Investments Are Taxed, H&R Block, available from: <https://www.hrblock.com.au/tax-academy/tax-on-dividends-investment-shares>
Notes:
1. Does not include the 2% medicare levy