Reaching Financial Independence under Australia’s Superannuation System and the “Two Bucket” Method

There is a controversy within the Australian financial independence and retire early (FIRE) community about whether to salary sacrifice into superannuation while you are young to get the tax benefits. (For international readers, “superannuation” or “super” is the Australian version of the American 401(k) or IRA, basically a retirement fund.)

When you salary sacrifice into your super fund, the money going in is taxed at 15% rather than your marginal tax rate. For example, if you are earning $100k per year, your marginal income tax rate is 37% so there are large tax savings to be made if you salary sacrifice into super.

However, there is a downside because you do not have access to this money in your super fund until you are 60. For many young people, this is too far away, so they’d rather take the money now.

In my opinion, if you earn under $37k, there are insufficient tax benefits to warrant salary sacrificing into super, but once you earn over $37k, additional income will be taxed at at 32% and 37% so you should be salary sacrificing.

The table below shows that once you earn over about $18k, additional income is taxed at 19% so the reduction to 15% is hardly worth it, but once you start earning over $37k, there is quite a large gain from salary sacrificing.

Australian income tax rates for 2018/2019 and 2019/2020 (residents)

Income thresholds	Rate	Tax payable on this income
$0 – $18,200	0%	Nil
$18,201 – $37,000	19%	19c for each $1 over $18,200
$37,001 – $90,000	32.5%	$3,572 plus 32.5% of amounts over $37,000
$90,001 – $180,000	37%	$20,797 plus 37% of amounts over $90,000

There are many arguments made not to salary sacrifice into super, and the most common arguments are provided below.

You may need the money while you are young e.g. to raise children, so you should not lock your money up in super

It is important to realise that there is a limit to how much you can salary sacrifice into superannuation. The amount your employer contributes plus the amount you salary sacrifice cannot exceed $25k, so even if you are salary sacrificing into super, there is still money you are not investing in super, so you are likely to have money outside of super to cover any unforeseen expenses.

Futhermore, when most people invest outside of super, they lock the money up anyway, e.g. they buy and hold ETFs or invest in property. It is true that ETFs and property can be sold to be used for necessary expenses, but there is a hassle involved, especially with property. There are large transaction costs involved in unwinding these investments including but not limited to capital gains tax. The only truly liquid asset is cash, and most people hold small amounts of cash to meet day-to-day expenses because they are aware that they can get better returns elsewhere, so why not apply the same principle to supernanuation and lock it up for the tax benefits?

Another consideration is that money locked up in super is still accessible in dire situations e.g. if you are bankrupt and living on the streets, you are able to access money in super via “hardship provisions.”

Another perspective is to look at money locked up in super as an argument for it rather than against it. Many people recommend getting an investment property as an investment because the compulsory monthly mortgage repayment provides “forced savings.” Since property is difficult and costly to unwind, this prevents the average person from raiding the piggy bank to pay for frivolous costs. Super can be seen as the ultimate form of “forced savings” because you cannot access it unless you are 60. Good money management is mostly psychological. Cash in your wallet is as good as gone because there is very little preventing you from spending it at the shops, but money in super is the other end of the extreme, and buying and holding shares or property are in the middle.

Forcing yourself to save money via a mortgage or superannuation is very useful for those who lack self-discipline, and while it is easy to think of yourself as being self-disciplined, most people are not.

Money outside of super can earn more than money inside super. Super is invested in shares and is therefore risky so you should leave money outside super and invest it in safer investments e.g. property.

This is a common argument given, that money in super is invested in shares, and most people perceive shares to be risky, so it is better to not invest in super and invest in property, which is perceived to be safe.

There is so much wrong with this idea. Firstly, most super funds invest not only in shares but also e.g. bonds and listed property. Furthermore, anyone can use a self-managed super fund (SMSF) to invest in almost anything, including Australian residential property (e.g. via BrickX).

Using an SMSF, it is possible to e.g. invest in residential property and even to leverage investments e.g. via internally geared ETFs. There are even margin loans designed for leveraging into super e.g. Nab Super Lever.

Another false assumption is that property performs better than shares. Many equity indexes perform just as well as property if not better. For example, looking at the historical performance of properties on BrickX, the best performing properties average 8% per annum capital gains, but the net rental yield of these properties is about 1.5% per annum. Historical performance of the STW ETF, which tracks the ASX200 index, as of July 2019, according to Bloomberg, also shows 8% per annum capital gains over five years, but the STW ETF also provides 5.93% dividend yield as at writing this, and that is not counting franking credits. If we look at equity indexes such as the S&P500, then performance is even better for shares. One could argue that other equity indexes have not performed well or that particular shares may not have performed well, but the same argument can be levelled at property. The 8% performance for property was plucked from the best performing properties in BrickX. Had you invested in other property, you would not have achieved these results. Furthermore, investing in shares allows you to easily diversify via index funds, and many super funds use either index funds or their active management policies require them to diversify globally, so you are getting instant diversification, but if you buy one house, you are not getting any diversification at all, which is a huge risk.

Furthermore, the argument that shares are riskier because they are more volatile is also false. The reason why stock prices move up and down quickly is because shares or ETFs are listed on the stock exchange. The price is disclosed whenever the market is open, which is every weekday. However, we only learn about the price of property when we buy or sell it or when we have an auction, and this happens very infrequently, e.g. every ten years. If there is an auction for a particular house every single day, there will be price volatility. Because there is not an auction every single day, this hides the volatility, but it doesn’t mean it doesn’t actually exist.

The fact that house price volatility is hidden also hides losses very well. For example, one of my friends had a mere $10k in his superannuation fund, and during the GFC his balance went down by $4k. He was so freaked out seeing the balance in his fund reduce so much so quickly that he withdrew all the money. He is an old man, so he is able to do this. However, this friend also owns a property that is valued at about $1 million, and in the recent 2017 and 2018 property price declines in Australia, the valuation of his property using CoreLogic data shows that his property went down in value to $800k, so basically $200k was wiped out, and he didn’t seem fussed at all. When my friend saw $4k wiped out from his super fund, he saw the balance go down instantly. He saw the market gyrations on the financial media and the stock market charts in free-fall. A mere $4k loss was enough to freak him out. However, when $200k is wiped out from his property, he doesn’t bat an eyelid. He knew in general that property prices were going down, but there is no dramatic price charts, and it is often uncertain to really know how much your property is worth. Most people have no idea. This story illustrates how irrational most people are with regards to property vs shares.

The government may change the rules and start taxing your super heavily.

This is another common argument against superannuation, that if you put your money in super, it is at the whims of government legislation. Supposedly if your money is locked in super, there is temptation for the government to increase taxes on super or increase the age at which you have access to it.

However, the problem with this argument is that even if you don’t put your money in super e.g. you put it into property or shares outside of super, it is also at the whims of government legislation changes e.g. if there are changes in income tax, capital gains tax, or franking credit legislation. Government can change anything, not just legislation that impacts on superannuation but also legislation that impacts on funds held outside of superannuation.

The only way you can avoid the risk of rising taxation imposed by the Australian government is to move your money into offshore havens or to e.g. cryptocurrency such as bitcoin, ether, or monero. However, offshore havens are not immune from the risk of legislation change. If your money is held in e.g. Bermuda, who is to say the Bermuda government can’t change its legislation? Cryptocurrency is also not a foolproof tax avoidance mechanism since crypto is still subject to capital gains tax by the ATO. There are other risks with crypto as well because even if you avoid countries and government, arguably the country or government in a crypto investment is the community of investors or the miners and the legislation is the protocol that governs how the crypto operates, and this is subject to change by developers. A whole book can be written about this, but basically there is no way to avoid risk of changes in legislation negatively impacting investments unless you diversify.

Contributing to super prevents you from retiring early

This argument is somewhat true but not as bad as you may think. Basically if you salary sacrifice into super, you don’t get access to the funds until 60, so if you are putting a huge amount into super, you may have enough to retire early but you don’t have access to it, which means that effectively your early retirement is deferred. To take an extreme example, suppose you need $1 million to retire, and you salary sacrifice so much that you have $1 million in super but nothing outside of super (because you use all your cash outside super to spend on expenses). Then you cannot retire until you reach 60 even if you managed to amass $1 million in super by e.g. age of 40.

However, as I stated before, there is a limit to how much you can salary sacrifice into super. The employer contribution plus amounts salary sacrificed cannot exceed $25k per year, so more realistically the amount you save outside of super should roughly equal the amount going into super. Rather than reach the age of 40 with $1 million only in super, chances are you will have $500k in super and $500k outside super. The amount outside super will likely be in e.g. ETFs, shares, and property.

Early retirement according to the FIRE community relies on the “four percent rule” i.e. your annual expenses should equal 4% of your net worth. If you reach age 40 with $1 million in your super, you cannot retire early and spend $40k per year because you don’t have access to the funds, but if you reach age 40 with $500k in super and $500k outside super, you probably can. Simply take the age at which you can access your super and subtract it by your age. In our example of someone retiring early at 40, this means there is 20 years left before he or she has access to super at age 60, so the money outside of super of $500k needs to last for 20 years. The simplest way to make sure you don’t spend over $500k in 20 years is to apply a simple straight line calculation and divide $500k by the years left, so in this case $500k divide by 20 is $25k per year you should spend before you have access to your super fund. By the time you have access to your super fund, that $500k in 20 years should be about $2 million assuming 8% per annum growth, and this means by the time you reach 60 you can apply the four percent rule and draw down $80k from your super per year. This is what I call the “two bucket system” and it is briefly explained by Aussie Firebug in his Australian Financial Independence Calculator as well as Mister Money Moustache in his article How to Retire Forever on a Fixed Chunk of Money.

Of course, retiring early on $25k and then suddenly reverting to $80k after 60 is a very weird way of implementing the two bucket method because I use a straight line method to draw down funds before access to super and then after access to super I use the four percent rule. Ideally you should use the four percent rule both before and after age 60 and arrange it such that you run out of pre-super funds just as you hit 60. This requires a much more complicated formula that Aussie Firebug has worked out in his spreadsheets above, but I believe that using the straight line method before access to super is much easier. The straight line method ignores growth in the pre-super funds, and so it is very conservative.

If you salary sacrifice heavily and use the straight line method to draw down funds before access to super, you will likely push early retirement out a little. If you are not willing to do this eg if you are absolutely determined to retire at age 40, then one way to still retire early while also salary sacrificing into super is to temporarily retire in a low-cost-of-living (LCOL) area e.g. Southeast Asia and then come back to Australia when you are 60 to access your super and retire here. The benefit of this approach is to use geoarbitrage to get the most bang from your buck in a LCOL area while you are young but then come back to a welfare state to access generous healthcare systems when you are older. However, this will be the subject of another post where I speak in more detail about retiring in LCOL areas as well as the “two bucket” system.