Do you read a lot of US finance blogs? The US-based finance content is excellent and comprehensive.
My favourites include Mr Money Moustache, the White Coat investor, physician on fire and the Choose FI podcasts. These are great for general concepts in finance and excellent for motivation to stick to the plan.
But which specific strategies can Australians apply to their own situation? All this talk about 401ks, IRAs and conversion ladders is a bit confusing!
The Australian personal finance space is growing, but still has quite a way to go to catch up with the US scene.
Australian Finance Translation- Sort of like concessional superannuation contributions, but employers don’t have to offer it and employees don’t have to contribute. Contributions and growth are completely tax-free (tax-deferred) until aged 59.5 years, in contrast to concessional super contributions and income which are taxed at 15%. On withdrawal from 401k, tax is paid, unlike most super contributions.
The Detail – Traditional 401K
The traditional 401k depends on employers to offer this retirement fund, so only ~60% of Americans can access it. Many employers offer a 401k “match” so that the employer will contribute extra to your 401k to encourage employees to contribute. Some employers tie conditions to their 401k contributions so that if you leave the company before a predetermined employment period, employees lose out on employer contributions.
Choices of Investments in a 401k vs Superannuation
The 401k, similar to your superannuation fund, is just a structure inside which investments are chosen. Choices within a 401k vary, similar to those inside super funds.
You can choose a managed fund, ETF and in some cases self-directed investments.
Depending on the amount of control a saver wants over their investments, the options available within a 401k or superannuation fund may help choose the fund.
In Australia, you can move your superannuation to a myriad of funds, based on fee structures, investment choices and historic fund performance.
In the US, employees are limited to the 401k options offered by their employer. Similar to superannuation, there are contribution limits that change with inflation annually.
Australian Finance Translation– Another employer-sponsored retirement vehicle, similar to non-concessional superannuation contributions. Post-tax income is contributed, so similar to non-concessional super contributions, there is no tax benefit on contribution. But withdrawals from a 401k after aged 59.5 years are tax-free, similar to all superannuation contributions after age 60.
The 401k is another employer-sponsored plan allowing the contribution of after-tax dollars. There are contribution limits each year of $19,500 combined contribution to traditional and Roth 401ks. Over 50s are allowed to contribute a bit more to ‘Catch up’. Not all employers offer any kind of 401K. Employees do not have to contribute anything.
Australian superannuation withdrawals are generally tax-free after age 60. The non-concessional contribution caps are generous, up to $110,000 or $330,000 over 3 years.
Individual Retirement Account (IRA)
Australian Finance Translation – IRA’s are like additional superannuation for low to moderate-income earners, or alternative for self-employed individuals and small businesses. Anyone can open this account, with their employer’s support. Tax advantages can be taken at the time of contribution, or on withdrawal depending on the account Americans choose.
IRA’s can be opened by anyone because they do not rely on an employer offering them. They offertax advantages, but these depend on the exact type of IRA that is opened. Eligibility for the tax benefits depends on your income, so higher-income earners miss out.
Americans can contribute to both a 401k (up to $19,500 pa total) and Roth IRA (up to $6000 pa total). IRA withdrawals before age 59.5 years incur a 10% penalty.
– Traditional IRA
Pre-tax contributions compound tax-free until withdrawal when they are taxed.
– Roth IRA
Post-tax contributions can be withdrawn after age 59.5 years tax-free.
– Simplified Employee Pension (SEP) IRA
Similar to a traditional IRA (pre-tax income, taxed on withdrawal) but for self employed individuals or small business owners.
– Savings Incentive Match Plan for Employees (SIMPLE) IRA
Australian Finance Translation – Similar to concessional superannuation contributions but simpler and cheaper to set up for small businesses to offer their employees.
These are offered by small business employers and are similar to a traditional 401K. An employer match is often offered. Pre-tax contributions are made and remain tax-deferred until age 59.5 years. The contribution limit is $13,500 per year.
Retirement Systems Australia vs US
I think you will agree with me that the Australian system is a whole lot simpler. The collection of retirement accounts basically replace superannuation for different employment situations and income levels.
It is clear that the Australian system will serve the majority of the population better. The US system relies on individuals contributing to a retirement account voluntarily, and from a young age given the relatively low contribution caps. It does not require employers to contribute to employees retirement. The complexity requires each individual to perform a significant amount of research to understand the best options for them, and this likely changes with each job change. It also significantly disadvantages those with employers that don’t offer 401k. I imagine this further disadvantages low-income workers. Companies looking to attract talent will offer these kinds of perks.
With the complexity of the US system, there is a chance ultra-optimisers can get ahead financially by making sure they utilise every option available to their individual situation.
Many US bloggers suggest filling tax-deferred investment vehicles (such as the traditional 401k and traditional IRA) first as most people will be in a lower tax bracket after retirement. They are better off claiming a tax benefit now, and paying minimal tax after retirement.
This conversation is echoed in Australia in the inside vs outside superannuation conversation.
Both the US and Australian systems are exposed to legislative risk. The government could change the rules, and the further you are away from retirement the more likely changes will affect you. But the Australian superannuation system is so advantageous that it would be crazy to completely neglect it (controversial I know).
US doesn’t have franking credit imputation system like Australia. In Australia, company income is taxed at 30%. This is taken into account once you are paid a dividend. If your marginal rate is 45%, you will only be required to pay the remaining 15% tax. If your marginal rate is 15%, you will receive a 15% tax refund! This only occurs with “Franked” dividends that have already been taxed inside the company.
In the US, dividends are still taxed at favourable rates in comparison with earned income. But this rate does vary with your household income.
Australian Finance Translation – the standard deduction is similar to the tax-free threshold for each Australian. In Australia, we can claim itemized tax deductions on top of this, at our top marginal rate.
Americans have the choice of itemizing deductions or claiming a “standard deduction” of a set amount each year. The tax rate for income over the standard deduction starts at 10%.
Marriage and taxation
In the US, legally married couples have to choose whether to file their annual tax returns individually or joint. Depending on their specific circumstances, one may be advantageous over the other. Double high-income couples pay extra tax when they marry (but not, I believe co-habit oddly).
An American married high and low-income earner will pay less tax, as their incomes will average out in a lower tax bracket than filing individually.
In Australia, you don’t submit a joint tax return but do declare your spouse’s income on your own tax return, and vice versa. Your joint income impacts your medicare levy surcharge liability and family tax benefits. Families with a single high-income spouse pay more tax than families with the same household income earner equally by the two spouses.
The ATO treats co-habiting couples and same-sex couples identical to married couples.
On becoming a couple, you become entitled to only one principal place of residence (PPOR) capital gains tax exemption between you. As singles, you were entitled to one PPOR capital gains tax exemption each. This requires some careful planning around which to claim as your exempt property when combining finances, and moving in together after both owning a PPOR.
Donor Advised Funds
One of my favourite US bloggers, Physician on Fire, is a fan of donor-advised funds. These allow donation of income or appreciated investments to your own charitable fund, from which you can choose and change the charities to invest to each year. It is non-refundable, so donating money to a donor-advised fund means you have committed to eventually donating it to charity.
You might choose to do this instead of just contributing annually to the advantage of a change in tax brackets. It’s an ideal move in the year(s) before retirement, or reducing hours. If a $100,000 donation is made whilst you are in the top 45% tax bracket, after the tax return, you will have only contributed $55,000 of your own cash. This money can be invested, and donated each year in accordance with the funds rules.
The same sort of fund does exist in Australia. Australian communities foundation offer a donor-advised fund. It would be nice to see the fees under 1%, but this is definitely something I will look into in more detail when the time is right.
Taxation of kids
Australian Finance Translation – Australians can employ their children and reduce taxation of their family business. Australians don’t have a specific investment vehicle they can allow their children’s investments to grow tax-free. The Roth IRA is used in the US, but kids can’t access this money without a penalty before age 59.5 years.
US blogs often talk about employing their own children in the family business, to take advantage of their tax-free threshold. If the child earns enough to make the fees worthwhile, some start a Roth IRA with the earnings. The child’s untaxed “Post-tax” income can be contributed and will grow tax-free until age 59.5 years. That’s thinking ahead!
The ATO Taxation Treatment of Children
You may have heard of the punishing maximum 66% Australian tax rate for kids. The ATO charges extraordinary rates for kids annual income over $417 to discourage parents from putting their investments in their children’s names.
But earned income is treated very differently.
If your child has a part-time job, their income is taxed as if they were an adult. This means a child can earn up to $18,200 before paying a cent in tax. Each state has child employment laws that limit the number and timing of hours worked.
Your child can put in after-tax money (or pre-tax if they earn enough to actually incur tax). Fifteen per cent tax will apply to income from investments inside super until kids reach their preservation age. And of course, there will be fees charged by the super fund. Withdrawal after 50 years or so of investing will be tax-free if the rules remain unchanged.
Investing for Kids Outside Super
Investment bonds have become very popular since their recommendation by the Barefoot Investor*. They are more tax-efficient than simply investing outside superannuation, but fees and underperformance can waste these advantages. They may be useful for double high-income couples.
Investing in a low income earning spouse’s name is often the easiest way to invest. A brokerage account could be opened in your child’s name. A couple of investments offer a dividend substitution share plan (not a dividend reinvestment plan). With this, instead of receiving dividends, the fund awards you extra shares instead. With a DSSP specifically, no tax liability is incurred until assets are sold. The sale would be timed after your child turns 18 and are in a low tax bracket.
Check out more detail on options in saving for children.
Whole and Term insurance
There is a lot of talk in US blogs and podcasts about whole and life insurance. Whole life insurance is a policy designed to be kept, as the name suggests, for your whole life.
Part of the premiums you pay are invested, and the policy can be “cashed in” if you have a change of heart. Its primary function is life insurance, to be paid out in the event of your death at any time to your loved ones. Term insurance is often recommended over whole life insurance because of
- Extra layers of fees within whole life insurance make it more expensive than term policies
- Your insurance needs over your life change signfiicanly depending on your stage of life. If you take out a policy as a single income family with young kids, a huge policy is required. This will significantly reduce over time as your debt is paid down and children become independent.
- The investment portion of the policy often produce suboptimal returns, likely at least partly due to the excessive fees and commissions paid.
In Australia, whole life insurance was phased out with the introduction of superannuation in 1992. Super is paid out to dependents on your death, so acts as a kind of insurance as you build up your balance. For years in which you need extra insurance, term life policies can be taken out within superannuation, and in fact, are often automatic. More comprehensive policies that are also more expensive can also be taken out through a financial advisor and deducted from your super. Read more about insurance here.
Australian Finance Translation
These are many of the US concepts I come across regularly in my reading and listening. I hope I’ve improved your understanding of what they are talking about!
What terms did I miss that you’d like to understand? Comment below and we’ll try and work out the answer.
Aussie Doc Freedom is not a financial adviser and does need offer any advice. Information on this website is purely a description of my experiences and learning. Please check with your independent financial adviser or accountant before making any changes.