But who wants to be foretold the weather? It is bad enough when it comes, without our having the misery of knowing about it beforehand.

_{Jerome K Jerome, Three Men in a Boat (1889)}

Tracking taxable investment income produced by the financial independence portfolio provides a useful external benchmark of progress on the journey.

So far, reviewing past dividends and distributions has been the primary way of tracking progress in portfolio income towards the financial independence goal.

Yet having this additional externally validated estimate of what my taxable income would be if I stopped working tomorrow is valuable. It helps illustrate the underlying income generating potential of the portfolio and also allows for broader trends over time to be observed.

Taxable investment income remains stable for now

Taxable investment income for financial year 2019-20 totalled around $42,500. This is a level which is close to the record of the past four years.

Figure 1 below sets out the fuller record over the past decade. It is based on the total of taxable income from the tax assessment categories of partnerships and trusts, foreign source income, franking credits and ‘other income’. That is, it takes in the totals of Items 13, 20 and 24 on the 2020 tax return, whilst not including capital gains.

The 2019-20 result means that the taxable investment income currently generated remains at only around half of the final required portfolio income goal of $87,000 per year (see Figure 2 below).

The gap, however, is not necessarily a critical problem. That is because the goal is not necessarily to have that exact dollar target met by portfolio income alone, which is only a part of the total returns of the portfolio.

The relative stability over the last four years has occurred over a period of substantial portfolio expansion.

As an example, in 2016-17 taxable investment income of around $40,000 was generated from a portfolio value averaging around $970,000. By comparison, across 2019-20 around the same level of income was generated by a portfolio averaging around $1.7 million over the financial year.

The portfolio is producing lower levels of taxable investment income for a few different reasons:

• Declining interest earnings – through a combination of reductions in interest rates, and a lower amount in tax inefficient interest-based investments such as Ratesetter over time. Through some parts of the past decade, for example, interest income totalled around $500 to $600 per month and an effective interest rate of up to 8 per cent was achievable on some funds.
• Changing mixture of investments – with a greater focus on Australian equities as a growing part of the portfolio since 2017-18, and associated franking credits.
• Different investment structures – with a changing balance between Vanguard managed index funds and newer exchange traded funds, noting that latter can have some tax efficiency advantages. As recently a January 2018, only 7 per cent of the equity assets of the portfolio were held in exchange traded funds. This compares to 41 per cent today.

An alternative view of portfolio income generation

The overall effect of these compounding factors can be seen best by considering trends in taxable investment income as a proportion of total portfolio size.

Figure 3 below sets out the level of taxable investment income as a percentage of the average dollar value of the portfolio over each financial year.

This shows a generally declining pattern of average taxable income as a proportion of the portfolio over the past ten years, reaching a low of just 2.4 per cent this year.

The shifting mix of taxable portfolio income

The individual components of the taxable portfolio income are also evolving over time. To illustrate this, Figure 4 sets out the major components by the different tax return classifications.

The largest change through the period has been an increase in income from partnerships and trusts (green). This is directly attributable to increased balances held in both Vanguard retail index funds, and the exchange traded funds.

Also evident in Figure 4 above is the declining level of interest income (dark blue). Interest income has declined from around one-fifth of taxable investment income to around 2 per cent over the past decade.

Additionally, the absolute level of foreign source income (purple) has increased as the level of foreign equity and bond holdings have increased over time. Foreign source income is up from 12 per cent to 16 percent of total income over the period.

The ‘other income’ (aqua) component has also increased. This increase almost wholly relates to parts of distribution payments from the Vanguard retail funds owned. Finally, the dividends component (red) represents the small amount of dividends received from directly held shares, and remains insignificant.

Looking at the current composition of taxable investment income in Figure 5 below reinforces the dominating role of ETFs and retail funds structured as trusts. Payments from these structures make up just under 7 in every 10 dollars received in taxable portfolio income this past financial year.

Some caveats and observations on the analysis

Looking at the taxable investment income in this way provides an independent snapshot of the real income generation of the portfolio.

There are some caveats, however.

An example of this is that this analysis includes the value of franking credits. As my previous post covering the changing role of franking credits discussed, these represent a major element of effectively pre-paid tax. So to some degree the taxable portfolio figures examined here represent a kind of simplified ‘pre-tax’ income measure.

In the past four years the level of franking credits received has increased substantially with higher portfolio levels and more investment in Australian equities (see Figure 6). As an example, the value of Australian equities in the portfolio has increased by more than $450,000 since July 2017.

This has had a direct and dramatic impact. Over the past two years, for example, around $8,000 per year of franking credits have been received. These credits currently make up around 18 per cent of total taxable investment income.

Looking outwards to the horizon…

In future years, the same trends seen so far are likely to continue.

Growing investments in exchange traded funds will see the trusts and partnerships component continue to dominate overall taxable income. Even if desired, it would be impossible to generate the level of fixed or interest income collected in the past in the current environment. Consequently, interest income is likely to drop away into further insignificance.

By far the largest foreseeable impact in the next few years is likely to be a reduced level of investment income from announced and future reductions in business earnings and dividends linked to the COVID-19 pandemic.

This is likely to represent rough weather on the outward bound leg of the journey, more easily foretold than avoided.