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Investing for Early Retirement

May 25, 2017

Investing for Early Retirement

Hindsight is funny.

It’s only after having taken a certain action that we can look back and see whether it was a good idea or not.

Only when we learn new skills or pick up new knowledge do we realise that the way we’ve done things might not be ideal.

I’ve thought about this a lot since reaching financial independence a few months ago.  There are a few things I would do differently if I was starting again and how I invested is one of them.

I focused too much on leveraging up in property to increase our net worth.  You can read about our experience with that here.  At the time, I (stupidly) didn’t worry about a passive income stream.

But I’ve learned that net worth only gets you so far.  Net worth, without passive income, is damn near useless when trying to retire early.

Instead, creating a growing income stream by your side truly strengthens your financial position.  Yes, you may pay some tax along the way, but it’s much more useful and powerful than using leverage to create spreadsheet wealth.

The most common form of financial leverage is to accumulate property, which usually chains you to your job whether you like it or not.  Quite often, you become equity rich, cashflow poor.

An income stream empowers you with the greatest leverage of all… the leverage to get yourself out of your employment shackles, giving you your freedom back.


Invest for Income

We have already considered briefly where we can put our savings to get started.

But to quit your job and retire early, you need an income stream from your investments that you can rely on.  There are many different retirement income strategies.

We need to keep in mind that this income stream needs to grow over time to keep up with inflation.  Essentially, when we’re investing, we’re really just buying an income stream.

If you buy an investment property, you get the stream of rental income from that house from now into the future.  When we buy shares, we get the income stream (dividends) from that company for as long as we own it.

Ideally, we want to purchase the most income we can for our money.  As long as we remember, that the income needs to keep up with inflation over time.  If the income stays the same, it won’t be very helpful in 30 years time.

This is because the money won’t go as far when paying your bills because inflation will reduce it’s purchasing power.  The income stream we buy needs to meet this criteria.

In my opinion, the best income stream to reach financial freedom as soon as possible is from Australian Shares.


Australian Shares

The sharemarket scares most people at first, myself included.  We are fearful of what we don’t understand.

It doesn’t help when scary headlines drum into us that the sharemarket is risky and goes up and down like a yo-yo.  When people do get comfortable with it, they often use the market to buy what I would call expensive lottery tickets.

These Aussie punters bet thousands on a speculative gold mining stock, lithium company, or whatever’s hot at the time and they then hope they’ll get lucky and the shares will go through the roof!

This is the totally wrong way to approach the sharemarket.  Get rich quick = get poor quick!

People focus way too much on the prices of shares and nowhere near enough on the dividends paid!

Getting a cheque in the mail or cash paid into your bank twice a year is unlikely to get your heart racing (although it does for me), but this is the real value of being a shareholder.

The whole reason companies are in business is to make profits.  Cash profits.  Behind the share prices are real businesses that are making real cash for their shareholders, regardless of what the share price is doing.

The true benefit of being a shareholder is the dividend income stream, not the price on the screen showing what someone else wants to pay for your shares.

When our shares go up in price, that’s a paper profit.  When we get paid a dividend, that’s a cash profit, passed from the company to us.  Forget paper profits and focus on cash profits (dividends).

I wrote in-depth about this dividend investing approach here.  Also hereHere.  And here.


Dividends vs Rents

Let’s do a little comparison to see how dividend income stacks up against rental income.

The average dividend yield for the Aussie Sharemarket is around 4% to 4.5%.  Perhaps we take an average rental yield on property (being generous) of around 4%.  To use even numbers, we’ll call them both 4%.

Are they really the same though?  Let’s see….

The property has expenses such as management fees, strata fees, building insurance, landlord insurance, council rates, water rates, vacancies, repairs and maintenance etc.  This will typically equate to around 30% or more of the rent.  This takes the rental yield down to 2.8%.

Now, the dividends we receive from most Aussie Shares are fully franked dividends.


Frank Who?

This basically means they come with ‘franking credits’ attached to them. We get a tax credit for the tax that the company has already paid on these earnings, before they pass them onto us as dividends.

Australia has this rule in place to avoid double taxation.  The tax credit is the same as the company tax rate, 30%.

You’ll receive the 4% dividend as cash.  The remaining tax credit will be available come tax time. This either takes care of most of the tax for us or becomes a tax refund if you’re in a low/no tax environment, such as early retirement 🙂

So an easy way of calculating the gross dividend yield from your shares, if they pay fully franked dividends, is like this…

Take your dividend and divide by 0.7.

4.00 / 0.7 = 5.71.

So our 4% dividend yield becomes 5.7%, once we include franking credits (as we should).  As you can see, it makes a massive difference.

So the rental yield becomes 2.8% after expenses.  And the dividend yield becomes 5.7% after franking credits.  That’s double!  Comparing the two streams of income, you can see that you’ll receive twice as much income from the shares.

This means an investment property worth 700k paid off will provide an income of 20k.  But the same 700k in Australian Shares will provide a income of 40k.  Don’t know about you, but I know which one I’d prefer!

Having a quick glance at the yields on offer and assuming they’re equal, can be very very deceiving. It’s downright dangerous!

Just out of interest, the property yield required to match the dividends is around 8%. Once you take away the 30% for expenses, rental yield comes to 5.6%, matching the shares yield of 5.7%.

Using these figures, a 4% dividend yield is equal to an 8% rental yield.  Always remember to add on the franking credits to work out the gross yield to make it a fair comparison to other income streams.


Which Shares?

It should go without saying that you can’t just buy any shares and hope to do well.  Almost everybody is better off with a set and forget type of approach, with minimal fuss and monitoring.

Picking winning stocks/companies is notoriously difficult and even most professionals struggle to outperform the market over time.  The simplest and safest approach to investing in the sharemarket is by buying an index fund, or a well diversified Listed Investment Company (LIC).

A stock market index fund will simply own all the stocks in the market index (such as the ASX 300, the biggest 300 companies in Australia) and achieve the same return as the market, after a small fee is taken out.

If going down this route, one highly regarded low cost index fund provider is Vanguard.  They invented the index fund, after all.  The gross yield of the Vanguard Australian Shares fund is usually around 5-6%.


Investing in Listed Investment Companies

Listed Investment Companies are just like a managed fund, that is ‘listed’ on the stock exchange.

A good Listed Investment Company (LIC) will invest in a large diversified portfolio of shares, with the aim of providing shareholders with a growing income stream.

Some of the oldest LICs such as Argo Investments and Australian Foundation Investment Company have been around for over 70 years, since before index funds were even invented.

Check out my LIC Reviews page for in-depth info of these companies.

These LICs both own shares in approximately 100 different companies, so you’re money is well spread around.  If a couple of companies in the portfolio do poorly, or even go bust, the overall portfolio will remain solid.

The gross yield (including franking credits) of these LICs is often close to 6%.  This means every $1700 invested will buy you around $100 of annual dividend income.

Every purchase you make, buys you more shares, which means more dividend income.  This means you get closer and closer to early retirement!

These LICs also have extremely low fees and their performance is quite similar to the market over the long term.  In my view, both index funds and low cost LICs are a great place to start investing for passive income.

Don’t forget to use a low cost broker so more of your money goes to investments, not fees.

Most importantly, make sure you’re using the dividends you receive to buy more shares, using compounding to start rolling a giant passive income snowball!


35 Replies to “Investing for Early Retirement”

  1. Great post SMA! We totally agree that shares are the way to go. I can understand the reasoning behind why ‘leveraging’ property seems good, but when it take in all the facts AND compare it to shares, there is no comparison. At least all those property investors are happily funding the banks’ dividends..

    Mr DDU

    1. Thanks Mr DDU! That’s a great way of looking at it.
      The big numbers associated with property often make it seem better and lures people in. But after all costs/hassles/poor income is taken into account, the income stream from shares is easily the best for financial independence. Wish I looked at shares sooner, but I’m a slow learner 🙂

      1. The whole purpose of property investing is to take advantage of leverage and compounding on a bigger asset base. After a property cycle or two, then think about converting that equity to LICs for the dividend income stream to fund early retirement 🙂

        1. Totally agree on the idea Jack. We actually still have quite a few properties. I just think that with a good savings rate, there is simply no need for leverage. You can just skip straight to the income phase. Sure you may pay a little tax, but you have more flexibility and regular/reliable returns through dividends.
          This way it’s simpler and at all times there is only extra income being received. No cash outflows and no debt makes life easier/more flexible. I didn’t appreciate this aspect before.
          Depends on your outlook for growth too. I suppose I don’t see much growth for property on the horizon now, not like it has been. Combined with very low yields, especially after expenses, it just becomes unappealing to me. If someones timeframe is less than 10 years, the purchase + selling costs will be too much of a drag also.
          Everyone has a different outlook though! Thanks for reading 🙂

  2. Great read! I want to reinforce what you have written. Properties are brilliant wealth accumulators. I purchased my first one at 18 and they are now freehold so should produce a nice passive income. I’m getting quite the income I had intended from them. Investment properties are NOT good retirement income investments! Mentioned in your blog were management fees, strata fees, building insurance, landlord insurance, council rates, water rates, repairs and maintenance (forgot loss of rent due to vacancies). My maintenance costs include 2 updated bathrooms, 2 updated kitchens, 3 sets of carpet the list goes on…. These costs put a huge dent in my cash flow. My share portfolio which produces a similar income does not have any of these costs! Thanks for all the GREAT blogs!

    1. Wow, thanks a lot mate!
      Ah, the vacancies, knew I would forget something! So many expenses to remember lol. Yes the leveraged capital growth can definitely work out great. But the income is quite woeful.
      The argument goes that the repairs, upgrades add value and tax benefits. To an extent yes, but the problem is they aren’t optional. Either you repair and upgrade or nobody will want to rent the property or high tenant turnover. Depreciation is bit of an illusion I reckon. It’s real money that needs to be spent regularly to keep the property decent and tenants happy. It’s not really a benefit.
      Great comment mate, thanks for sharing!

  3. I have been building an International share portfolio of using VGS ETF inside super and using Argo and AFIC outside of super for early retirement purposes.

    The merits of using LIC’s outside of super as a wonderful tax friendly (100%franking) are very obvious, but I’m unsure of their usefulness inside Super, so I am using VGS inside super which will eventually be transferred to a pension account at some point when I’m old (20 years hence). I use Choiceplus inside he Hostplus platform as a SMSF lite version and NABtrade for my AFIC Argo portfolio outside of super. It is great to hear that you give LIC’s preference …. sometimes I feel like I’m in the minority re my love of LIC’s!

    1. Great work Phil!

      With super taxed at only 15%, franking credits are still very useful. Half the franking credits would be refunded to the super account. It’s hard to beat a 15% tax rate!
      Although it’s not all about tax benefits, we need to look at after-tax return also.

      I like your way of thinking. I use basically the same strategy, although we have some individual shares in our super. With all the talk of international diversification, I personally think it’s fine to just switch your super to international shares and let it ride over the decades. To me, that’s fine for international exposure. Our personal portfolio outside super will stay heavy on Australian Shares for early retirement income… and the international shares in super compounding away for some old man money 🙂

  4. Firstly, nice blog. I only found it yesterday through seeing your comments on Pat’s blog. Secondly, I had never heard of LICs so thanks for that. I will definitely be looking into them.

    As for the shares Vs property debate, I think it is entirely dependent on the individual circumstances.

    I’ll give you my situation as an example….

    My wife and I own 7 properties. 2 in Sydney the rest in various large regional cities. 1 of those was our residence until we moved to a regional town for work and began renting. It is now an investment property. In total the portfolio has only increased in value about 10% over the last 5 years. Not spectacular by any means.

    However, 5 of the 7 are rented through the NRAS program. I wont explain the full details of that as it would take too long. The important part is that the program provides us with just over $50k tax free in incentives each year for 10 years. All the properties are positive cash flow due to a combination of rent, those NRAS incentives and tax deductions.

    Now, taking into account our savings rate from our employment, rent, tax deductions and the NRAS incentives, we are able to save the equivalent of 110% of what would be our entire after tax take home pay from just our jobs. Beat that for a savings rate!! 😉 There is just no way we could be retiring as soon as we are if we had relied solely on non-leveraged shares bought through after tax savings.

    Having said all that, in another 5 years when the NRAS incentives stop we will sell the portfolio down and put it all into shares. The yield is better with shares and it is way less hassle as well. For a steady, stress free retirement income it is a no brainer to us.

    1. Thanks for coming, glad you like the blog 🙂

      Appreciate you sharing your story – interesting!

      Well it certainly sounds like it’s working for you which is all that matters. You’re saving a boatload, and well on your way to early retirement, so that’s awesome. Congratulations!

  5. Great article Dave, loved it. Can you teach me something about dividends?
    Say for example (in the most simplistic of terms) you bought $1000 of CBA shares, currently $50 per share. So you get 20 shares for your investment. These all pay $2 dividends twice per year. Accumulating $80 of total dividends. It would take 12.5 years of dividends to cover the cost of your initial investment, and then all dividends paid out from that point would be pure profit. But am I lead to believe that dividends could grow in that time? Decreasing the time it would take to cover the initial investment? How does it compound? Is the example given above an example of 8% return on investment?

    My confusion with the dividend approach seems that it would take quite a while to recoup (in dividends) the initial layout cost you invested. I understand this is the same with property and collecting rent $500 a week on a $500,000 home loan. But with shares as you mention, there’s no upkeep cost such as maintenance or lack of tenants.
    Any help here getting my head around it would be great. Thanks

    1. Glad you liked it Linc.

      Usually when people take the dividend investing approach, this is what happens…

      Say they buy an LIC (for example) which has a dividend yield of 5%. When they receive a dividend they can use it to purchase more shares, meaning next year they will receive a higher dividend because they own more shares. Also, the company/LIC should increase its dividend over time (most years) meaning they will receive a higher income for the same amount of shares. And also, as the investor saves money they will purchase more shares on a monthly or quarterly basis, meaning their ownership increases and therefore their future dividend income increases. So these 3 factors are all working to increase the investors income stream over time. And of course if a company has higher earnings in the future and paying higher dividends, it will also mean its more valuable, so the investment will grow in value over time also.

      Hope this makes sense, happy to elaborate further if need be.

  6. At what point do you stop re-investing the dividends and start taking an income (my guess is when you think it’s enough to retire on)

    Also when you start to do this, does the compounding still continue to happen or stop due to taking the dividends as an income?

    1. Yep exactly – once you think the dividend stream is enough for you to live on.

      When you start to receive the income, your portfolio will stop growing as rapidly of course, but it will not stop growing. Because as companies in your LIC/Index Fund increase profits over time, they increase their dividends too, which will be passed through to you. Over the long term, profits and dividends generally grow with or mostly ahead of inflation, meaning it’s a sustainable income stream to live off.

      You can see how dividends grow over time, even without continuing to buy more shares in my LIC reviews, like this one.

      Plenty of other articles on the site to have a look at which should help explain this message further 🙂

  7. This very article changed my life. I changed my entire point of view from thinking about share PRICES to living off DIVIDENDS instead. It makes so much sense and I like what you said about buying yourself an income. I’ve got around 6 years left until I’ve got the magic Million saved up and can retire early. I’m going to use your Dividend strategy to achieve a retirement income (plus maybe a bit in RateSetter though I’m a little concerned about their recent flurry of rule changes). Thanks for writing this article which is a true inspiration.

    1. Wow thanks so much, this comment made my day!

      Good stuff Hunter, exciting times ahead it seems 🙂

      The change in focus from prices to shares was a real game changer for me too, that’s why I feel compelled to pass it on. Really glad it’s helped you. If you haven’t read them already, there’s a bunch more dividend investing articles elsewhere on this blog you’ll enjoy.

  8. As you were building your portfolio of lics up, when you were at the point of getting 30k dividend cheque did it feel amazing to put it back on the market? did you dollar cost average?

    1. We’re still building it Andy. We still have quite a bit tied up in property for now. We’re getting a good lump of dividends each year, now over 20k, and we mostly use that cash to buy more shares. But we still have bills to pay too of course, so some of it goes there. Yes we dollar cost average, we try to buy shares each month provided we have enough spare cash.

  9. Another great article Dave. I wished I’d known more about investing 20-30 years ago. Being mid 50’s I don’t have much working time left to make a great deal of difference, but I’m putting what I can into LIC’S, every little bit counts. I’m passing on every bit of info to my kids to hopefully make there life easier.
    Keep up the great articles mate, I’m slowly getting through them, even reading them several times.

    1. Cheers Don.

      Many people never get started, so well done for that. And great stuff passing on the investment info to your kids, hopefully they take advantage of it. Thanks for reading!

  10. Hi Dave, started work January, 1950 in a bank and progressed through to being a self employed CPA for 30 years plus but now retired. To my mind Peter Thornhill’s approach has investing by the throat and together with your blog it gives everyone a great platform to work off. I am now 84 years old and take it from me the advise/directions you discuss are just as relevant to me now as to all your other readers. I might say I discovered LIC’s some years ago which have contributed to my retirement very nicely. Congratulations and please keep it up. Robert Chaplin

    1. Robert – thanks so much for this comment, I really appreciate it! Great to know that someone with your experience still finds this blog useful.

      Happy to continue the good fight (pushing the dividend approach), and have a number of investing articles lined up for 2019 🙂 Thanks again.

  11. hi Dave,

    thanks for some great information and congrats on your own success

    i just want to be clear on something please if you don’t mind..

    A tax question,

    If i place 1 Million dollars into AFIC for example, and my return on my investment after 1 year is 5.7%.

    My income/dividend will be 57k

    How much tax will i pay if i don’t earn any other income?

    thank you

    1. Hi Darren,

      I use this online calculator as a good estimator for tax outcomes.

      So if you receive $40k cash dividend and $17k franking credit (as in your example of 5.7% gross yield), your gross income is $57k. Tax payable on this income is roughly $11k. But since you have $17k of franking credits, this covers the tax and there’s $6k left over. Under current franking rules you’d get a $6k refund and end up with $46 of after-tax income.

      But if Labor axes the refunds for excess franking credits, you’ll simply receive the cash dividend – $40k in this example – and no refund. Those extra $6k of tax credits could be used to offset any tax owing on other income of course, but in this example you’d end up with $40k after-tax income.

      Hope that helps!

  12. ok thanks for going through that example for me

    although the result seems a bit disappointing as i’ve heard a number of people (some bloggers, forums, scott pape, among others) suggesting that for 1M in AFIC for example, that you’d receive 57K ?

    why does anyone mention getting 57K if its 46K or 40K ?

    which doesn’t seem the case now, as best case scenario will be 46K, and worst case 40K?..

    so if labor gets in its straight up 40K in the pocket only?

    i appreciate you explaining all this..

    1. Because that’s the after tax figure. Tax is just a fact of life when you earn any kind of income or profit.

      It’s important to look at it in terms of gross income to compare it to other assets. $57k is the gross income you generate from your ownership in this case. If you receive $57k rent from a property after costs, same deal, you have to take tax out after that.

      Currently split between a couple this would be $28.5k each, which is $26.5k after tax each. $53k after tax combined. It’s actually a pretty generous tax system.

      Also, those in retirement over 65 often pay zero tax so they would clear the entire $57k. Your after tax figure simply depends on your tax rate, so depends on personal circumstances – that’s why everyone uses the total figure.

      Yes, if Labor gets in they plan to stop franking refunds, so the income generated would be $40k after tax, per $1 million. In my view, that’s still pretty good for a reasonably diversified and hassle free income stream which grows over time. Up to you whether you prefer this or other options. Generally higher yield options involve more risk.

  13. Fair enough…the 53K from 57K sounds pretty efficient lol

    we’re only 51, but those in retirement over 65 often pay zero tax?…can you expand on this please?

    Also, just so i can fully understand the tax you mention on the 1M because we receive it in our banks each year?

    What if i had a 2nd 1M in AFIC and dividends that i just rolled over and not received into my bank?..does that make any difference to the tax payable each year?

    thanks again

    1. Well you can switch your super fund into ‘pension mode’ where you pay zero tax on the earnings from those investments. Actually this tax free super starts at 60 if you declare yourself fully retired. Then you can also own assets in your personal names and those are also tax free up to around $30k per year per person. See more here.

      No if you reinvest the dividends you still have to pay tax because it’s still classed as income that you’ve received yet chosen to reinvest. AFIC do offer a plan that has been approved by the ATO which allows you to receive new shares rather than a dividend (similar to a reinvestment plan but different for tax purposes). The catch is you also do not receive franking credits and may pay higher CGT if you ever sell.

      This can be an efficient way to accumulate shares if your tax bracket is higher than 30%. I wrote a bit about how it works in this post.

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