I'm starting to think about the principles of asset location for the Australian prospective early-retiree. There has been a fair amount on asset location and early retirement written from a US perspective, from SIPP and backdoor Roth IRAs to the simple bonds in 401k 'rule' but I haven't read much from an Australian perspective. I may be coming from a different set of assumptions than many so it would be good to get other input. I'm not a tax expert and don't know your individual situation but hope this spurs thought and discussion.
My starting points:
- I'm aware of the likelihood of tax changes over the coming decades but not paranoid about it. "They" are not coming for my Super any more than my other assets. The plausible worst cases are restrictions or additional taxes on lump sums, or slightly later access-age but as I am planning to live a long life and will have assets outside super these make only a marginal difference. So for example, while my partner is still far from retirement and making a decent income, I think it is worth her salary sacrificing as much as possible to take advantage of the lower tax rate but we don't make much in after-tax contributions.
- I'm assuming a desire for diversification, both across countries (Australian and International Shares) and asset classes (including some bonds or cash). If we keep everything 100% in Australian Shares, for example, then there aren't so many asset location decisions to make (although if some of our assets are less passive then keeping those in super can reduce tax costs).
- I'm not focused on gearing. For those whose whose preferences and situation are such that they are willing to trade off a (hopefully small) risk of complete loss of capital for an accelerated path to financial independence only the parts on International and Australian Shares will probably be relevant. If I was borrowing for direct property (and I'm not) then I'd be inclined to do it outside Super. The costs and regulatory risks seem much higher in Super and the tax deductibility of lending more effective on a high marginal tax rate outside Super.
- I'm assuming we will also have assets outside Super. An early retiree will likely need them to ensure a desired (even if frugal) lifestyle until Superannuation "preservation age".
Those caveats out of the way, what is asset location and how does it differ from asset allocation? Asset allocation is the proportion of Australian Shares, International Shares, cash, etc. across all our accounts and is a substantial driver of risk and return in a portfolio. Asset location is figuring out which assets to put in Super and which should be held outside Super.
Once we hit preservation age, we can more-or-less freely substitute money inside and outside super. But even before then, as long as we have enough to meet current needs there is a degree of fungibility. We can, for instance if we need access to cash for spending, sell shares outside super and buy similar equities in super while keeping our overall asset allocation static.
Why should asset location matter? Largely due to different tax treatment and to a lesser extent due to the availability of online savings accounts. Briefly on the latter, online savings accounts, while not as attractive as in the past, currently give us an expected yield higher than 10-year Australian government bonds but with much lower volatility. Sure, if interest rates fall further bonds will experience capital gains but equally if interest rates rise bonds will fall in value in the short term. By being relatively small we're able to access the government guarantee on deposits which large super funds cannot. This may not continue forever but it is a good deal right now and relaxes some of the arguments below for keeping fixed interest in Super.
What are the different tax treatments?
Australian Shares: Franking Credits on Dividends, Capital Gains discount if held > 12 months.
A-REITs: A bit messy, but typically not much in the way of franking credits.
Cash and Bonds: Taxed as ordinary income.
International Shares: Withholding tax credits on Dividends, Capital Gains discount if held > 12 months.
Australian Shares get tax advantages inside and outside Super.
A-REITs are a pain to keep track of for tax purposes and usually get tax advantages inside Super.
Cash and Bonds get tax advantages only inside Super (while your marginal tax rate is positive).
International get tax advantages both inside and outside Super (while your marginal tax rate is positive).
Given a desired asset allocation and a current value of our Super vs. Non-Super assets where would I start. I assume a reasonable income gives a current marginal tax rate above 30% so that the tax benefits of Super can be substantial.
I'd start with any A-REITs in Super (and extend this to unlisted property and infrastructure as well as any tax-inefficient alternatives).
At the other end I'd start with Australian Shares outside Super (particularly passive index or buy-and-hold-forever strategies).
For fixed interest, if I hold Bonds I'd hold them second after REITs in Super, if Cash I'd consider the after-tax return of an online savings account vs. something close to the RBA cash rate after 15% tax (which is what our Super will probably earn in their Cash option). Cash is also handy in that you can spend it when needed without any taxable sales required, so I lean towards a decent amount outside Super.
If I have space left after REITs and considering fixed interest then International Shares are interesting for early retirement. If we are not frugal at all then either inside or outside Super is fine, as we will potentially get back withholding tax and be eligible for capital gains discounts. It may be a hassle/may not be possible to claim back more than $1,000 in foreign tax credit so I'd lean towards holding some International Shares in Super if possible.
If we are at the Senior Mustachian end of the frugality spectrum then having more of our International Shares in Super makes even more sense to me. The reason is that if we become financially independent with many years until we have access to Superannuation then our tax arrangements can invert if we stop working. That is, after capital gains discounts and franking credits, we may end up with a 0% tax rate outside Super but are still paying 15% p.a. inside Super. We cannot get back foreign withholding taxes on dividends if we don't pay any tax but our Super fund still can.
I also haven't touched on Investment, Insurance, or Imputation Bonds. These require some more individual calculations to judge their worth, particularly for early retirees where you may be on a low or 0% individual tax rate after retirement. There are pitfalls you should look into using these, and the fees are not as competitive as index ETFs or low-cost Super funds, but my understanding is when they are used correctly the tax paid within the structure (on dividends, say) is 30% minus any credits, but after 10 years there is no Capital Gains Tax payable. It seems they may be suited for high-income earners' International Share allocation with a roughly 10 or more year timeframe to retirement so I'd be interested in hearing others' views.
TL;DR, we still have a muddle which depends on individual tax situations (how long until retirement, how much taxable income needed after retirement). But for many people with early retirement planned for the next decade, say, my rule of thumb (with International Shares and Cash the main areas of doubt; maybe do a mix of both if borderline).
REITs/Alternatives first in Super
Bonds second in Super
International Shares third in Super [But some Cash or a mix may be better]
Cash in Super and/or online savings account outside Super
Australian Shares last in Super
Once in early retirement, having more of any Cash allocation outside Super may make sense, particularly if you are frugal and so have a 0% tax rate outside Super.