How the other proposed Labor tax changes would affect FIRE

Most of the articles that the FIRE blogging community has produced about the proposed Labor tax changes has focussed primarily on the removal of cash refunds for franking credits, presumably because there is a heavy focus on Australian shares and living off the dividends.

It’s fair to say that this is a pretty contentious issue but given that there is no shortage of posts on this subject already including my own work, I want to talk some of the other proposed changes which haven’t received as much attention. 

This is going to be a two part post with the first one focussing on the proposed changes and the second one focussing on what effect it will have on the plans I’m making for my situation.

It’s important to note here that there is not a whole lot of detail about how some of these proposed changes would actually work, and of course Labor would have to win power and then be able to get the legislation through the Senate, receive royal assent, and survive any court challenges before we have to worry about any of this stuff.  So we’re dealing very much with hypotheticals here.

Also when reading this please bear in mind that this is the interpretation of a random guy on the internet who is most definitely not an accountant or tax expert and whilst I try to get it right it’s pretty much the same as when you check your stuff in at the cloakroom, this is all care but no responsibility! 

It’s going to be pretty embarrassing if things go wrong and when asked why you did something a particular way the answer is because random internet guy said to, so for all our sakes but especially your own please don’t do that.  And now moving right along…

Discretionary Trusts

The big change here is that instead of being a pass through entity where whatever money comes in gets distributed straight back out to the beneficiaries without any tax being applied within the trust, discretionary trusts would have a 30% tax rate on distributions.  Currently if you have a discretionary trust with income of say $10,000 then you would distribute that $10,000 to one of the beneficiaries and it goes straight to them without being taxed within the trust or upon distribution, the calculation of tax is based on their individual circumstances.

So under the current system if you’re still building up your wealth and have a non working spouse or even one who is in a lower tax bracket than you then you’d send the $10,000 to them, zero tax or lower tax payable by them, happy days. 

If you’re both working and in the same tax bracket then just split the distribution 50/50 between the two of you, unless you’re making a spouse contribution to super and the extra income would reduce the tax offset or it would push one of you but not the other into the next tax bracket.  You get the idea I’m sure. 

If you’re already retired and have your investments in a trust then you probably split the income between the two of you so you get to use the tax free threshold of $18,200 each (it’s actually more like $22k because of various offsets but let’s keep it simple) and can basically get about $36k in income without paying any tax.

With the proposed changes though, no more of that pass through status.  The trust is now paying tax at 30% on the income it distributes so that $10,000 you were receiving, whoops it is now $7,000, presumably with a $3,000 franking credit although it isn’t clear that this would be the case in anything I’ve read.

Under the current system this would presumably still be fine because you could claim that franking credit as a cash refund if you’re paying more tax than you would otherwise, but under the proposed Labor system you wouldn’t get a cash refund on tax already paid by companies and presumably wouldn’t on tax already paid by trusts either. 

If you’re thinking no problem I just won’t have the trust distribute the funds then, sorry but the trust has to pay the highest marginal rate of tax ie which is currently 45% but is proposed to be 47%, so you’re better off distributing the funds rather than holding onto them.

Therefore if you own shares or an investment property in a family trust because you want to be able to stream the income or protect your assets or a variety of other reasons, you’re now subject to a minimum 30% tax no matter what your individual tax rate is. 

This probably makes no difference to individuals who are still earning an income and building up their wealth, and it’s the same for couples where both people are working and have a marginal tax rate of 32.5% or higher.

But if you’re already retired, or have a non working spouse or adult children not earning an income and were planning on streaming the income to them, well now it’s a 30% tax rate and that’s from the first dollar of income.  No tax free threshold for you!  As a comparison to be paying an average rate of tax of 30% in your own name you’d need to be pulling down about $135k as a wage earner!

Now plenty of people don’t use trusts because of the added cost and complexity so this isn’t something that is going to affect more than a small percentage of people.  Pat the Shuffler has written about why he doesn’t and his reasoning makes sense given he wants to keep things simple and he has a relatively simple situation.  Aussie Firebug has written about why he uses trusts though, and it’s probably a more common investment vehicle for investment property owners who might now become a bit more sympathetic to investors in shares who are facing the loss of the cash refund on franking credits.

So to my mind this proposed change would pretty much kill the idea of investing through a discretionary trust if you were doing so in order to be able to stream income, although they are certainly still good for asset protection and some other uses. 

You’re not going to be able to reduce your tax when you retire by investing through a trust unless you’re looking at a seriously high income (well over $100k), and you may well be increasing it, so why do it unless you have a strong need for asset protection etc?  It can still potentially help a bit while you’re building up your wealth if you have different marginal tax rates between a couple or a family but the benefit is likely to be a lot smaller for most people.

Now personally I’m not sure why you should be able to stream income from a discretionary trust anyway because it does seem like a major loophole.  It’d be nice to think there was a good reason for this when it came into being (if any of my readers know it then please let me know in the comments or drop me an email), but I’m a bit more cynical/realistic about politics than to assume that there was actually a decent rationale. 

But if the problem is that people can stream income to someone in a lower tax bracket, then maybe this is the aspect that should be changed rather than changing the taxation structure of discretionary trusts? 

Lastly, one other point on this is that apparently it is not clear that franking credits would actually flow through the trust under the Labor proposal according to this postby the Chartered Accountant association who presumably know a lot more about this stuff than I do.  It has been informally indicated apparently that this would still occur, but as there is no detail on this (as is the case with much of the rest of the proposed policies) so we don’t know for sure.  You’d assume that this will be the case, but you know what they say about assuming!

Increasing the top marginal rate of tax

This is going from 45% to 47%, add on the medicare levy and you’re paying 49% to the government for every dollar you earn over $180,000.  I think there is still a budget repair levy as well if you earn over this amount, so near enough to half of what you earn over that $180k is going to the tax man.  There’s not much more I can tell you about this, I don’t want to say it’d be a nice problem to have but if you’re pulling down that sort of money then hopefully you’re in a good financial position anyway and can afford the extra tax.

Capital Gains Tax

Another proposed Labor policy is to halve the capital gains tax discount for individuals.  Currently if you hold an asset for longer than 12 months, you get a discount of 50% on the capital gain when you sell it so you pay less tax.  Under the proposed policy that discount is reduced to 25%, ie you would have to pay more tax because you have a higher taxable income.

Now this probably doesn’t have much effect at all if you’re not planning to sell down assets to fund your retirement.  If you’re invested in properties and plan to just live off the rent, no worries.  If you’re invested in most broad market ETFs or LICs and are planning on just living off the dividends, apart from whatever small capital gains is distributed to you this probably won’t make much difference.

But if your plan is to sell down your assets over time to fund your retirement, then this is potentially going to be an issue.  Labor has said that grandfathering will apply so any assets you own before whatever date they pick (presumably sometime in the future but who knows) will still get the 50% discount. 

Anything you buy after that date, only a 25% discount.  So you’ll be paying more tax and therefore have less after tax income to fund your retirement, which means you either need to sell down more assets to get the same income or sell down the same amount but live off less income.

Also complicating this is that if you owned shares and were previously getting a cash refund on your franking credits or had an investment property in a trust and now your income is reduced by as much as 30%, then you’re going to need more income as well.  In any case, it’s not ideal.

To be honest I don’t think it will have a huge impact if you’re selling down shares to fund your living costs.  You’re probably selling down maybe $40,000 a year or so maximum, you’ve got a tax free threshold or maybe two to work with, so sure the proposed change may increase your tax and reduce your income somewhat but it’s not going to make a huge difference given the low amounts and the low marginal tax rates we’re talking about here. 

Where it is far more likely to be an issue is if you are selling down large assets like property.  If you buy a property after the grandfathering date for say $500,000 and sell it a few years later for $700,000 after fees then you have a capital gain of $200,000. 

Under the current system you get a 50% discount so $200,000 x 50% = $100,000 discount so $200,000 – $100,000 = $100,000 added to your income for the year.  Under the proposed system you only get a 25% discount so $200,000 x 25% = $50,000 discount so $200,000 – $50,000 = $150,000 added to your income.

If we magically assume this is your only income for the year which seems extremely unlikely but makes the math a bit easier then you’re up for tax of $24,497 under the current policy and $42,997 under the proposed policy.  Calculations are all done here.

So after selling the $700,000 property under the current scenario you would have $700,000 – $24,497 = $675,503, under the proposed scenario then you would have $700,000 – $42,997 = $657,003 which is a difference of $18,500.

I don’t know about you but $18,500 sounds like a decent whack of money to me!  If you had other income already then the situation would get worse if you cross over the $180,000 income mark and start paying 49% tax. 

This is also going to be a pain from a records keeping perspective because when you acquire the asset determines the tax treatment upon sale.  In fairness this is already the case with CGT, there are already different rules for how your capital gain is determined depending on when you bought them.  Still, I would prefer less complexity rather than more if possible if anyone is listening?

https://goo.gl/images/586te5

Franking credits

I’ve already written about this here, Dave at Strong Money Australia wrote about it here, Alex and Ellie at HisHerMoneyGuide wrote about it here, Steve at Value Investing for a Living wrote about it here, from outside the FIRE community Cuffelinks wrote about it here, honestly I think it’s been pretty well covered now and I really hope I don’t have to write anything more about it.

Negative Gearing

Labor is also proposing changes to negative gearing.  To be honest I don’t feel like I have my head around this well enough to try and explain the differences, there isn’t enough detail to really flesh it out anyway, and this post is already way too long and I reckon I’m going to be struggling to find enough pictures for the rest of the post so this isn’t a wall of text.  Do you guys know how hard it is to find free stock images about discretionary trusts and tax stuff???  In any case someone else can write about this one. (Edit: Ask and ye shall receive! A Family on Fire have done this post on the topic which I think addresses it really well)

Conclusions

One of my main takeaways from this is that absolutely no one is going to be individually better off as a result of the proposed changes.  You may be paying the same amount of tax, you may be paying more tax, you will definitely not be paying less tax. 

An argument could be made that whatever additional revenue is raised will be spent wisely and in in the interests of us all so we’re collectively better off, but hahahahaha no this strikes me as being extremely unlikely.  In case you’re wondering I feel the same way about either of the major political parties and government in general, less is better.

https://www.youtube.com/watch?v=RUilUzH5kx8

Another takeaway is that from what I can see some of the proposed changes seem to be trying to fix the wrong problem.  If the problem with franking credits is that SMSFs in pension phase can get a big cash refund, then change the tax rate on pension phase for all super funds rather than changing franking credits.  If the problem with discretionary trusts is that you can stream income which is what is highlighted in the press release, then change them so you can’t stream income rather than making them pay 30% tax on distributions.  Maybe there is something I am missing here?

Overall the proposed changes are all likely to make it harder to build up wealth, generally require more assets to generate the same amount of income depending on the source and holding structure of those assets, and overall make it tougher to achieve FIRE.  I really can’t see anything that is going to help, it’s just a matter of whether it will hinder you or not. 

What’s your take on the proposed changes?  If you enjoyed this post and would like to read more like it then please subscribe!