People always find something to worry about.
The FI community – and wealthy people in general – are no exception.
One of those concerns is taxes.
Specifically, if we’re living off our investments, how much will tax eat into our returns?
It’s natural to wonder about such things. Because if we’re leaving the certainty of full-time employment, then we want to make sure there’ll be no nasty financial surprises on the other side.
Thankfully, things are much better than you might expect!
In this article, we’ll explore the topic of taxes after reaching financial independence. I’ll run through some specific examples and explain the tax outcomes in each case.
Investment income, franking credits, capital gains, part-time income – we’ll cover it all!
By the end you’ll have a good grasp on how to deal with taxes when it’s finally time to kick off your work shoes and sprawl out on the lush green grass of early retirement.
Before we begin
In an effort to keep this article simple (it’s still 2,000+ words!), I’m unable to cover the limitless possible examples.
Think about how many things could alter your personal tax outcome…
— Single vs couple.
— Continued earnings vs fully retired.
— Using trusts and structures or not.
— High yield or low yield investments.
— Property, shares, or a combination of both.
— Dividends with full, part, or no franking.
— Using capital from selling assets or the natural yield.
— Portfolio size and tax bracket.
And of course, we’re talking only in the Australian context. Taxes are different elsewhere, so you’ll need to figure out what taxes apply to your specific situation.
As a warning, this post is number-heavy. If you prefer, feel free to skim, read the summaries and then the other sections 🙂
Regardless of your situation, take the below examples as an interesting starting point and a source of inspiration to go and check out your own numbers.
Our taxes since 2017
Regular readers will be aware that we own a combination of property and shares.
We left work with mostly property and some shares. We’re selling off the properties over time and building the share portfolio since it’s far more efficient at generating cashflow.
In the early years of retirement, our taxes were zero. In fact, I was accumulating tax losses one year after another. Why? Because our properties were still producing a cashflow loss and I had no other income.
(Side note: in the early years, we used proceeds from selling property to pay for these losses, our personal living expenses and invest in shares, as explained here)
As our share portfolio has grown and we’ve sold off property, these tax losses have now been used up. In addition, interest rates came down (until recently) and I started earning some income, putting me into positive territory for tax purposes.
We’re now just starting to pay more tax again, as our cashflow has improved. I’ll admit, this scenario is highly unusual from an early retirement perspective, but I wanted to share how we’ve fared tax-wise. Don’t worry, the below examples are much simpler!
Living off a $1m share portfolio
Let’s use a simple example of a $1m portfolio of 50/50 Aussie and global shares (not an instruction, just an example ASIC… relax).
We’ll assume the dividend yield is 3% (split between 4% for Aussie shares, 2% for global). That’s $30,000 of dividend income hitting the bank during the year ($20,000 Aussie and $10,000 global).
Following the often used 4% rule, our retiree may wish to harvest another $10,000 from global shares to end up with $40,000. This effectively evens things out and brings the portfolio back to 50/50 (ignoring market movements for simplicity).
So, what’s the tax outcome?
Worst case, let’s say your share sale resulted in a 100% capital gain. By the way, you can decide which portions of your holding to sell to improve the tax outcome.
You’ll need to keep very detailed and precise records to do this though. Alternatively, if you’re a lazy shit like me, you can just rely on Sharesight (affiliate link) to keep track of this for you so you don’t have to worry about it.
Anyway, that’s $5,000 of capital gain to declare. Less the CGT discount for owning longer than 12 months. That’s now $2,500 of taxable gains.
There’s also about $5,700 of franking credits from the Aussie dividends, assuming 75% franking.
To calculate these numbers, I’m plugging them into this calculator. Despite others being prettier (like this version), the one I’m using includes things like the low income tax offset which makes it more accurate.
Numbers below are also rounded for simplicity. And FYI, the term ‘gross taxable income’ is what the total income tally would be in a tax return at the end of the year.
Cash received during year: $40,000 (dividends + share sale)
Gross taxable income: $38,200 (dividends + franking + taxable capital gain)
Tax owning on this income: $3,800.
Tax already paid: $5,700 (franking credits).
Result: $1,900 refund (approx.)
End position: $41,900 after tax.
Overall tax on cashflow: 0%.
Gross taxable income: $19,100 each (half of above).
Tax owing on this income: $0.
Tax already paid: $2,850 each (franking credits).
Result: $2,850 refund each.
End position: $45,700 after tax combined.
Overall tax on cashflow: 0%.
In both cases, our early retirees are faced with zero tax bill. In fact, both receive a tax refund due to surplus franking credits.
But what if you have higher expenses and therefore need a bigger portfolio?
Living off a $2m portfolio
Maybe your target investment income is more like $80,000.
By the way, you may not need as much as you think in retirement if your home is paid off.
Let’s look at the tax outcome using the same approach as above. The portfolio would produce $60,000 in dividends, and another $20,000 is created by selling off a few global shares.
Side note: if you’re finding it tough to stomach the thought of selling shares, I wrote an article detailing my own mental conflict with it and how I came to reframe the idea: My Latest Thoughts on Dividends and Diversification.
We’ll again assume a profit of 100% on the shares sold, so $10,000 of capital gains, $5,000 of which will be taxable thanks to the CGT discount. Franking credits on the Aussie dividends amount to around $13,000.
Cash received during year: $80,000 (dividends + share sale)
Gross taxable income: $78,000 (dividends + franking + taxable capital gain)
Tax owning on this income: $17,300
Tax already paid: $13,000 (franking credits)
Result: $4,300 tax owing (rounded)
End position: $75,700 after tax.
Overall tax rate on cashflow: 5.4%
Gross taxable income: $39,000 each (half of above).
Tax owing on this income: $4,000 each.
Tax already paid: $6,500 each (franking credits).
Result: $2,500 refund each.
End position: $85,000 after tax combined.
Overall tax rate on cashflow: 0%.
Our couple again has no tax bill to worry about despite this higher level of cashflow. And our single is facing only a small amount of tax to pay.
Well shit, things are looking pretty good so far! But what if you plan to work a bit after reaching FI?
Adding part time work after FI
OK, now tax will definitely be higher. Your employment income comes with no other tax-friendly benefits like investment income often does.
And with this extra income starting to creep into the higher tax brackets, it will start to have a noticeable effect.
Anyway, let’s pick a spot in the middle of the previous two examples – a target FI income of $60,000 per year, or $1.5m shares.
We’ll assume part time work of $30,000 per person. This is equivalent to perhaps 2-3 days per week. This would likely be taxed by your employer at around $2,700 for the year, leaving you with $27,300.
The $1.5m portfolio produces $45,000 of dividends (and $9,600 in franking credits). In addition, $15,000 of global shares are sold for a gain of $7,500, half of which is taxable (we’ll round it up to $4,000).
Cashflow received during year: $87,300 (dividends + share sale + PT income)
Gross taxable income: $88,600 (dividends + franking + taxable capital gain + PT income before tax)
Tax owning on this income: $20,900
Tax already paid: $12,300 (franking credits + PT income tax).
Result: $8,600 tax owing.
End position: $78,700 after tax.
Overall tax rate on $90,000 of total income: 12.6%
Cashflow received during year: $57,300 each ($114,600 total – same as above except 2x PT income)
Gross taxable income: $59,300 each ($118,600 in total)
Tax owing on this income: $10,500
Tax already paid: $7,500 each (franking credits + PT income tax).
Result: $3,000 tax owing each ($6,000 total).
End position: $108,600 cashflow.
Overall tax rate on $120,000 of total income: 9.5%
Tax is starting to become noticeable now given we’re hitting six figures. Even still, it’s only eating into around 10% of overall cashflow, with the couple having the slight tax efficiency advantage.
Keep in mind, they might be doing this extra work more for enjoyment than earnings.
And in reality, they’d likely start receiving small tax bills throughout the year from the ATO rather than a big surprise at the end of the financial year. Tax is also becoming a little more complex now given the various moving parts.
Semi-retirement, surplus wealth and spending levels
We could go into more examples but let’s leave it there.
For those considering semi-retirement AKA semi-FI – where your investment portfolio isn’t enough income to live off just yet – adding part-time income to the mix, in most cases, will still keep you in a happy position of relatively low tax overall.
We can see that, all the way up to the six figure range, tax is barely even worth thinking about. So those planning to retire on $1m-$2m (or even semi-retiring on less) are going to be left wondering why they ever worrried about tax in the first place!
No need to move to Dubai, or arm yourself with a team of tax-saving specialists in an attempt to ‘protect your wealth’. Keeping things simple will do just fine.
But we can see that tax – although still low – does creep up once we’re in the higher income zone. For our example, this is mainly due to the fact that income starts coming from less tax-efficient sources like employment.
In many cases this is ‘bonus income’ being earned after already achieving FI. So, if tax starts to become an issue or a pain at these upper levels, then diverting money into super is a solid option. This surplus wealth, which may not be needed given their existing portfolio, can then compound in a more tax-friendly environment.
And yes, there are changes being made to super tax rates as I write this. But it’s likely that super will remain more tax-efficient and generous than personal tax rates . In any case, at this higher level it’s a golden problem to have!
It’s also worth noting this is another area where big spenders are at a disadvantage. Only those chasing so-called ‘Fat FIRE’ or very large numbers that’ll will need to worry about tax eating into their cashflow.
But if your FI goal is investment income of $50,000 as a single or $100,000 as a couple, then based on the above portfolio, in retirement you’re gong to be faced with zero tax bill at the end of the year.
By the way, I assure you this portfolio (50/50 Aus/Global) wasn’t chosen for any other reason than simplicity for the example and to show a more complete picture where both dividends and capital gains were used.
Reminders on tax
There are too many possibilities to cover here. Go and play around with a tax calculator (like this one or this one) to see how things look for your own personal situation.
And remember, choose investments based on their own merit, not on the tax outcome.
Yes, tax impacts our returns. But trying to reduce or ‘optimise’ tax can really pollute people’s thinking. They become so focused on not paying tax that all rational decision-making goes out the window. Don’t let the tail wag the dog.
Let’s be clear: if you retire early in Australia and end up paying lots of tax on your investments, it’s because you have a huge portfolio. Hardly something to be upset about!
And again, this ‘problem’ can be improved by beginning to move surplus wealth into super.
Ultimately, tax is massively overestimated as an issue in retirement or when living off a share portfolio. The brain space we give it far exceeds its importance.
The reality is, shares are extremely efficient at producing passive income in a tax effective (and hassle free) way.
Aussie shares typically mean solid dividends and a hefty chunk of tax credits waiting for you with the ATO. Global shares mean lower yields and harvesting tax-efficient capital gains from the portfolio.
The result: you’ll be pleasantly surprised when it comes time to do your tax return, even when living off a good-sized investment portfolio.
Apologies for the numbers and complexity in this post! There’s not really a simple way to explain this without showing you.
Hopefully fleshing out these examples helped put a few minds at ease 🙂
Your overall tax rate when living off your investments will depend on a lot of things. But whether or not you plan to work after hitting FI, tax is NOT something you need to stress over.
The Australian tax system is relatively friendly for early retirees like us in the FIRE community. Especially those generating their cashflow from share investments, thanks to franking credits and the CGT discount.
And at the end of the day, that means more cash in your pocket… for coffee dates, camping trips, or whatever the hell you plan to do once you leave the rat race! 🔥