My treasure’s in the harbour, take it.

_{Shakespeare, Antony and Cleopatra, Act 3, Scene 11}

Introduction – why analyse taxable income investment?

Each year measuring taxable investment income produced by the financial independence portfolio has provided an alternative independent benchmark of progress on the journey to the portfolio goal.

This measure is distinct from the regularly reported portfolio distributions, through being generated entirely from annual tax records.

Generally, my portfolio income analysis focuses solely on ‘after-tax’ dollars received in the bank account as the primary data. This is reported twice a year.

Nevertheless, this separate annual series of taxable investment income can also help illustrate progress. For example, it can highlight exactly what my taxable income might be in the absence of any paid work. That is, if early retirement was taken today.

Last year some analysis showed some broad trends. More time and new data, however, now provides the opportunity for a longer and fuller view of trends in taxable investment income across the journey.

This longer read post expands the analysis from the last review. It builds into this review data from four additional years of tax records covering the earlier phases of the journey.

The theme of this analysis is how the momentum of gradual progress can build over 15 years, turning a breath of wind into a powerful force through time, and compounding as the years pass.

Along the way it also corrects some minor inconsistencies in data reporting on dividends and franking credits in earlier years of previous analysis.* It also refines the analysis through a greater focus on income from income-producing financial assets, rather than all portfolio assets.

Taxable income investment grows significantly over 2020-21

Taxable investment income for financial year 2020-21 totalled over $68,000. This is a more than 60 per cent increase from the past two financial year totals of around $42,000.

Taxable investment income is defined here as the combined totals of taxable income from the tax assessment categories of partnerships and trusts, foreign source income, franking credits and ‘other income’.

That is, the measured taxable investment income is the total of Items 13, 20 and 24 on the 2021 tax return. Capital gains under Item 18 are excluded.

Figure 1 below shows the levels of taxable investment income for the past fifteen years. This is expanded to cover four additional earlier years, from 2006-07 to 2009-10.

The years covered at least in part by this record are in green.

Substantial progress on the financial independence portfolio recommenced in financial year 2006-07 with the purchase of a house and repayment of the associated mortgage.

Following this, the portfolio sat at a total of around $85,000, meaning that this 15-year period covers the vast bulk of the ‘accumulation phase’ of the journey.

This point is also emphasised by Figure 2 below, which expresses the taxable investment income each year as a proportion of the nominal final portfolio income goal of $90,500 per annum.

From this it can be seen that overall progress on the journey, having being essentially reset in 2005-06, then moved forward relatively steadily.

In fact, by the start of 2017 a position was reached of investment income equivalent to around 40 per cent of the target portfolio income being generated.

Yet this past financial year has delivered an unusually high result, with investment income growing suddenly to meet three-quarters of the target income level – or 76 per cent.

This reflects the higher than average distributions over the past year and growth in the underlying income generating portfolio.

Mapping the portfolio level and investment income growth over the journey

The relationship between the overall portfolio level and the income that the portfolio generates can be illustrated in a couple of ways.

Most directly, it can be shown by plotting taxable investment income against the average portfolio level over the same year.

Figure 3 below does this on with income in blue on the primary (left) axis, and the portfolio (red) on the secondary axis on the right.

It shows, as might be expected, a quite close relationship between the overall level of the portfolio and the income it has generated. In fact, the correlation is even closer than might be expected given some of the factors at play.

As an example, the portfolio level recorded here included non-income producing assets such as gold and Bitcoin.

In addition, the composition of investments changed over the period, with progressively lower levels of fixed interest holdings.

Finally, and accentuating this impact still further, interest rates declined significantly over the period.

Income generation as a proportion of the portfolio

The other way to express the relationship between the portfolio level and income is by measuring the level of taxable investment income generated as a percentage of the average dollar value of the portfolio over each financial year.

Figure 4 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 relatively steady pattern of income generation of around 3 per cent over recent financial years, while the average value over the full period is 3.7 per cent.

Due to the presence of the same non-income generating assets mentioned above (gold and Bitcoin), this measure can be distorted through time by rises and falls in values of these assets. In turn, this obscures the true underlying income generation characteristics of financial assets owned.

For this reason, Figure 5 below provides an equivalent chart, but with income instead measured as a proportion of all financial portfolio assets – i.e. the total portfolio with gold and Bitcoin holdings removed.

The overall pattern is quite similar, but the ratio of income to portfolio is proportionally higher.

Here, however, the investment income ratio is more purely a measure of the rate of distributions, dividends and interest income received over time from the financial assets in the portfolio.

Nonetheless, over the period the average income generation from portfolio financial assets is quite close to the previous result, at 3.8 per cent over the period.

What lies beneath – the shifting mix of taxable portfolio income

Under the broad surface of the taxable investment amounts, the individual components of the taxable portfolio income are also continuing to change.

The chart below (Figure 6) sets out the major components by the different tax return item classifications of partnerships and trusts, foreign income, dividends and interest over the longer data series.

The most significant feature through the 15 year period has been an increase in income from partnerships and trusts (green).

This follows mathematically from the increased balances held in both Vanguard retail index funds, and the exchange traded funds. Both the Vanguard retail funds and the exchange traded fund adopt these structures.

Looking further beneath the surface – trends in interest, foreign income and dividends

What can also be observed is the rise and then gradual fall in level of interest income (dark blue) over the long-term.

Interest income reached a peak of around $7,500 in 2013-14 and was routinely over 30 per cent of all taxable income from 2011 to 2014.

After this, however, it has steadily declined to make up less than one per cent of income this past financial year. This is a function of the sustained withdrawal of funds from income assets, such as peer-to-peer lending, and also of falling interest rates.

By contrast, 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 19 percent of total income over the period.

At times, foreign income has made up a quarter of all investment income. With the ongoing re-positioning into a more even allocation between Australian and foreign equities, this element can be expected to continue to rise.

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 is generally inconsequential through the entire period.

Shape of taxable investment income components for the current financial year

Focusing more closely on just the composition of taxable investment income over the past financial year in Figure 7 below reinforces the general emerging picture of the dominating role of ETFs and retail funds structured as trusts.

Payments from these structures make up exactly three-quarters of the dollar amount received in taxable portfolio income this past year.

The invisible breath – the expanding role of franking credits

An important additional consideration in taxable income is the role of franking credits.

A recent monthly portfolio update post updated the level of franking credits received in the last financial year, and looked at recent trends.

Franking credits represent a major element of effectively pre-paid tax. This means that to some degree the taxable investment income figures examined in this analysis represents a simplified ‘pre-tax’ income measure, the taxation on which franking credits will reduce.

Figure 8 below reproduces this recent chart, indicating the level and sources of franking credits.

Over the past four years the level of franking credits received has increased substantially with higher portfolio levels and more investment in Australian equities.

As an example, the value of Australian equities in the portfolio has increased by more than $700,000 since July 2017.

This has had a marked effect on franking credit levels.

Over the past three years, for example, between $7,000 to $8,000 per year of franking credits have been received.

In the same period franking credits have therefore effectively added between 10 to 16 per cent to total taxable investment income.

Another way to view the overall impact is to illustrate the combined taxable investment income (i.e. Items 13, 20 and 24) and franking credits.

Thus Figure 9 is the same as the previous Figure 1, but with the value of franking credits distributed added back in.

The result of this is a type of headline or nominal ‘pre-tax’ income amount. A number conceptually similar to, for example, a normally advertised salary.

As can be seen, by this measure investment income has tracked between approximately $40,000 to $50,000 for previous years of this record, but has jumped this immediate past financial year to $76,000.

A building current – the growth of taxable capital gains

The primary focal points for this record to date have been regular reporting on the level of portfolio distributions, and to a much lesser extent, the alternative measure of taxable income investment.

My financial independence goal, however, is based on a total realised return approach. That is, combined returns from both income and any capital gains, rather than other approaches that seek to draw only on dividends, for example.

Previously I have looked in some detail at the capital gains that have flowed through the Vanguard retail funds, and tracked the significant variations in these amounts over time.

In recent years, I have also had an annual total aggregated capital estimate included at Item 18H of the tax return.

This measure therefore gives an additional metric on the level and significance of capital gains made in recent years.

Figure 10 sets out the level of annual capital gains reported over the past seven years.

Note that the amounts in this chart are the total capital gains reported in Item 18H, not the net capital gain assessable in Item 18A.

The net gains reported in Item 18A are in each year approximately half of the total gains, due to the 50 per cent capital gains concession on assets held over a year, and the low turnover of the portfolio.

What can be seen from Figure 10 is that there has been a general increase in the level of capital gains as the portfolio has grown, with a markedly higher level of capital gains in the last financial year.

This generally is consistent with the high levels of total portfolio distributions over the same period (for example, over $135,000 in financial year 2020-21).

Indeed, the shape of total portfolio distributions – as might be expected – largely maps to the pattern of capital gains above. This reinforces the point that capital gains can often be drivers of any outsized portfolio distributions.

Evolving task of managing of taxation liabilities along the journey

An emerging issue in this second half of the journey is how to sustainably manage higher and more volatile tax liabilities arising from portfolio growth and distributions.

Over time this has evolved from simply receiving larger than normal tax bills, at the start of the journey, to (involuntary) enrolment in a ‘Pay as You Go’ (or PAYG) instalment system, under which quarterly notices and tax bills are generated by the tax office.

These PAYG instalments represent a form of regular pre-payment of expected liabilities arising from non-employment related income.

My past practice has been to set aside 25 per cent of the cash value of all distributions, to meet both annual liabilities and the required quarterly notice amounts. This set aside amount is held in a separate cash account.

This financial year, this approach has come under strain, as it has for others on the same journey.

Due to the significantly higher portfolio income this year, lodging the 2021 tax return recently generated an annual tax liability of around $31,000, in addition to the quarterly installment amounts – of around $3000. Payment of this lump sum is due in March 2022.

Over time, the quarter pre-payment amounts estimated to be required by the Australian Taxation Office will likely rise to reflect more recent increases in investment income. This will presumably lower the annual one-off liability.

In the interim, however, I have increased the amount saved automatically each month to ensure cash is there to meet this obligation, and I will increase the amount set aside from distributions from 25 per cent, to 30 per cent.

Over the next several years I will reassess the adequacy of this approach.

Observations from tracking the true winds of taxable investment income

The six main insights I have gained from reviewing this longer record of taxable income data are:

• An overall story of steady growth in total investment income – Taxable investment income this past financial year has moved significantly above levels over the past four years, however, it is yet to be seen whether this is a just temporary phenomenon.
• Resting on a relatively stable rate of income generation of about 4 per cent – There has been general stability in the income generation from the financial assets in the portfolio over the past decade, with an average income rate of around 3.8 per cent of the portfolio value.
• With growing foreign income sources – Despite lower overall dividends from foreign equities and the small role of foreign bonds in the portfolio, foreign income is growing substantially.
• Australian franking credits are helping boost after-tax returns – Franking credits are making a material contribution to after-tax returns annually.
• Instability and expansion in portfolio capital gains – Capital gains have emerged as a major and difficult to predict factor in portfolio management and distributions over the past five years, as the portfolio has approached the FI target.
• Reinforcing a need to focus on planning for tax impacts – Managing the taxation impacts of the portfolio is likely to require further attention and refinement.

This is the most comprehensive review and analysis of the taxable investment income on the journey so far.

Many of the trends and insights observed here are likely to endure for some time. Some, however, such as tax management, can be expected to be affected with any future movement from full-time work.

Last year reviewing past trends, I forecast a likely reduced level of taxable income in 2020-21. Instead, taxable investment income actually expanded by more than 60 per cent from the previous year.

This suggests that while the ship and treasure may be currently in harbour, many more events can seem likely to occur than will transpire with any certainty.

True winds cannot be plotted in harbour, rather they will be only felt and experienced in the peril of the journey.

* Explanatory Note:

The figures derived for this analysis differ slightly from earlier shorter examinations of the taxable income records. From initial inspection these differences appears to flow from an inconsistent counting of franking credits as part of taxable income in my earliest entries in monthly portfolio updates in September 2018, September 2019, and in the initial trends analysis undertaken last year. In these cases, franking credits were in some instances added to taxable investment income, in an approach similar to that undertaken in Figure 9. There may be other minor sources of differences, flowing from other factors such as transcription errors, or revised annual tax statements from providers. The analysis in this post has addressed these inconsistencies and should be taken as the most complete.