How is tax calculated in retirement
Today is my favourite segment: “Your questions answered” and today’s question comes from Sven, who asked me:
If I earn $50,000 per year from a super income stream and then I earn $18,000 from bank interest, is that 18k tax free or is it added to the 50k and that sets your tax rate at 32%? Or I earn $18,000 in fully franked shares on top of my 50k in super income what are the numbers there. Thank you very much for cleaning this up. P.s I think I will be coming to you when I get close to retirement. Love your stuff.
First of all – thank you Swen for your question, and big thank you for following my videos and my Newsletter.
In order to answer this question, we are looking at couple of scenarios:
Scenario 1
- $50,000 income from superannuation income stream
- $18,000 interest earned from bank, for example from a term deposit
What is the tax bill in this scenario?
Well first important aspect of this income is $50,000 from super income stream. As long as this is your retirement income and not for example a TTR Pension (Transition to Retirement Pension), there is no tax payable on income received. What’s more this income is not even part of your taxable income. It does not need to be included in your tax assessment.
Therefore, if we can disregard $50,000 income for tax purposes, in this instance, only $18,000 is your taxable income.
Considering that this level of income is below our $18,200 tax free threshold, there is no tax payable. Obviously if your income earned from investments is greater than the tax-free threshold, then your tax bill will be calculated as per usual formula as per marginal tax rates scale.
Scenario 2
- $50,000 income from superannuation income stream
- $18,000 earned as fully franked dividends from Australian Shares
So what is the difference between income earned from the term deposit or any other cash bank deposit and fully franked share dividends?
Well, fully franked share dividends are the best tax idea introduced in Australian tax system.
Similarly to Scenario 1, your $50,000 income from your superannuation income streams is fully tax free. We have already established that before.
Your $18,000 dividend income is also below the tax-free threshold, therefore also not subject to income tax.
But it gets so much better that your term deposit, because shares have what we call fully franked credits. I will create a separate post to explain in detail this very important aspect of tax system in Australia. And unlike most other rules in our tax system that favour the high-income earners, this one works the most for retirees and super funds or pension funds.
The lower your tax rate, the better your benefit – that’s the unintended outcome and a benefit.
So as per option 1 you might be very happy with your outcome of not having to pay tax, in Scenario 2, where your income comes from share dividends, you will not only not have to pay tax, but you will actually be eligible for a tax refund.
It works like this:
Dividends received to your bank account – $18,000
On your dividend statement you will receive the information of the level of franking credits attached to your net dividends received in your bank account
If your income from shares has been $18,000 net with fully franked dividends, that means that your grossed up income must have been $25,514.
So the difference is the amount of $7,514.
This is the amount you can claim each financial year, when you complete your tax return.
Why are you receiving the tax refund? It is because franking credits represent the tax a company has already paid on any profile it distributes to shareholders as a dividend.
As you can see there is a great deal of difference in earning income from cash or term deposit and shares.
To earn $18,000 in cash rate or dividend rate, you would need to have invested $360,000.
Scenario 1:
- You invested $360,000 into a term deposit at 5% for 12 months – your return earned is $18,000, and as discussed before, if this is your only taxable income, there is NIL tax to pay. Well, you might be very happy with this outcome, but
Scenario 2
- You invest $360,000 into Australian Shares that pay fully franked dividends, you receive a net dividend distribution of $18,000, but… those dividends also come with the attached franking credits of $7,514. That means that the full, grossed up dividend actually is $25,524 and if your tax rate is 0%, you are entitled to a tax refund.
Which scenario gives you a better outcome? Can you see now how beneficial it is to invest into Australian shares and derive income with fully franked dividends? This is your reward for investing into a more volatile world of shares and supporting Australian businesses.
I do hope this explanation makes the comparison clear. As mentioned before, I will create another video to fully explain the issue of franking credits as it appears to be very confusing for many. This is why those who understood this amazing tax system, will concentrate on investing into Aussie shares. But please don’t forget that diversification is still essential.
If you would like to discuss with me your share investments or would like advice how to create a solid share portfolio or any other financial or retirement planning topic, just book a meeting with me to go over your personal situation and to find out how I can assist.
By: Katherine Isbrandt CFP®
Money Strategist & Retirement Planner
Principal of About Retirement
