Listen on:

Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.

Mark LaMonica: Okay, Shani. So right before we started recording this, you were telling Will about the incident at your house today.

Jayamanne: Yeah, I wouldn't call it an incident.

LaMonica: Okay, maybe it's not an incident, but the backstory is, for people who have listened before, they should know that you have a dog named Priscilla. Priscilla does not like being left alone.

Jayamanne: No, very much a COVID dog. It gets anxiety and barks a lot.

LaMonica: Which makes your neighbors very unhappy with you.

Jayamanne: Yes, so I live in a terrace house, so I share walls with two other houses, so they're really not happy about the barking, which is fair enough.

LaMonica: Which is understandable. So what you've done is you have hired dog sitters.

Jayamanne: So they come over every day that I'm not working from home or my husband's not working from home.

LaMonica: I mean, I think most people get the concept of a dog sitter. But anyway, thanks for that explanation.

Jayamanne: Well, no, apparently. So the dog sitter that came today, he said, I've never been to someone else's house. The dog always comes to me.

LaMonica: Well, yeah. Look at him.

Jayamanne: I know.

LaMonica: Well, I mean, I guess that shows Priscilla, you know, when you get someone to come to you, shows who has the power in their relationship. But this guy's new. You've never had him before.

Jayamanne: Yeah, exactly. He's just moved to Australia a month ago. He works at (indiscernible).

LaMonica: Yeah.

Jayamanne: This is a lot of personal information about my dog sitter. I probably shouldn't be giving it out.

LaMonica: Well, exactly. Well, anyway, he messaged your husband today asking if he could eat your lunch and have a beer.

Jayamanne: Yeah. So, I mean, I said, help yourself to coffee and whatever's in the kitchen. So I guess this was my fault, but I have had a big few weeks of work and life. And so I decided to order some pre-made meals. And then I ordered exactly enough for the week for both me and my husband. But now we have one less.

LaMonica: So what's going to happen? Are you just going to miss a meal or is McDonald's going to be biked over to you?

Jayamanne: This has just, increased my mental load. Now I have to think about where am I getting this one meal from?

LaMonica: Exactly. And it's going to cost you some money, which ties into what we're talking about today, because we're talking about income.

Jayamanne: We always speak about income.

LaMonica: We do, but that's because everyone is interested in income, especially passive income. And passive income is an attractive goal. It is especially attractive when it starts replacing your salary.

Jayamanne: Many people dream of having passive income because it gives them financial freedom. It is to receive income without having to work for it. Whatever work means for you, maybe a dog sitter. It also allows you the financial freedom to stop that work and for you to be able to perceive a passion like a dog sitter, as well as live comfortably without relying on government support.

LaMonica: Okay. Well, a lot of dog sitter talk today. But to replace your salary, intuitively, you need income producing assets. And we've done numerous podcasts around how to generate passive income through dividends and how to create a sustainable stream of those dividends. Let's go right back to the basics, because this is only one of the ways that you can start generating income.

Jayamanne: And there are several major asset classes or avenues that offer income-producing assets. There's labor, so that's the jobs that you and I do to get a wage or a salary. There's the age pension, which is a government allowance that you need to qualify for. There's fixed income, where you receive interest. There's cash, where you receive interest.

LaMonica: And of course, there's Aussie and international equities that have dividends or distributions, depending upon how you hold them. There's listed property, where you receive rent in the form of distributions. And there's real estate, where you just receive rent.

Jayamanne: And there are pros and cons to each of these. Every single one of these assets or avenues are passive, except for labor. So if you're after passive income, all of these avenues can contribute to that goal.

LaMonica: However, some have more advantages than others. For example, Aussie equities may have franking credits that will bolster your return. Listed assets also have fees, transaction fees and potentially management fees.

Jayamanne: Real estate has negative gearing. It also has interest expenses in most cases and property maintenance costs and potential vacancy periods. We'll stop there with the pros and cons of these asset classes, but you can find a table that I've put together, which compares them all, as well as an average income generated for each. So we'll link the article in the bio.

LaMonica: But it's easy to see from this comparison that not all income is built equal. There are different levels of effort, tax treatment and risks.

Jayamanne: There are several major asset classes or avenues that offer income producing assets. The idea for this episode came from a book that I recently read, and it's a book on tax, Rebellion, Rascals, and Revenue: Tax Follies and Wisdom through the Ages by Michael Keen and Joel Slemrod. And I actually read this part of a book while I was by a pool in Sri Lanka, a few cocktails down and somehow entered it into my phone notes to come back to later, which I think is pretty impressive, to be honest.

LaMonica: I agree. I agree. So in this book, or so Shani tells me, the author's opinion is that permanent income, which is income from capital such as land, dividends, from equities and interest on debt, should be taxed more heavily than precarious income, which is income you make from labor, so either trade or a profession.

Jayamanne: And he was arguing that the greatest ability of the permanent capital required a lot less sacrifice from people and it promoted inequality. He goes on to say that there is no deduction for the depreciation of human capital, which encompasses skills, your physical ability to perform labor, knowledge and experience.

LaMonica: And I am depreciating by the minute in every single second.

Jayamanne: By the second.

LaMonica: Yeah, by the second in every single way. So he quoted a former Chancellor of the Exchequer, Herbert Asquith, who was also a Prime Minister after that. And he said, you might derive an income each year from a perfectly safe investment in government bonds, perhaps accumulated as inheritance, and another person making the same nominal sum by personal labor in the pursuit of some arduous and perhaps precarious profession. To be taxed in the same way is, to my mind, flying in the face of justice and common sense.

Jayamanne: And regardless of whether it flies in the face of justice, it reinforces that not all income is built equal. In the pursuit of passive income, the less sacrifice required from you, whether it's time, expensive labor or tax, the more passive it becomes and the more permanent it becomes. The concessions given to some forms of passive income can be the foundation of building wealth.

LaMonica: And that quote that we talked about was obviously at a time when a blue collar labor was much more common than white collar labor. The connection is very easy to make about how labor depreciates. As you get older, your physical ability to complete blue collar tasks decreases.

Jayamanne: Labor also depreciates from white collar work. With white collar work, our capacity and labor depreciates due to reduction in time horizon and the plateau of income earning. So I spent most of my life building up my human capital. I built my human capital through a strong education and took on debt to achieve this. After graduating from university, I was wealthy with human capital and that was because I had time. I had negative financial capital because I had a net position of around $40,000.

LaMonica: As time moves on, human capital depreciates. What we want to do is we want to balance the scales. And the way that we balance the scales is we create permanent capital and income. A dollar of permanent income is worth more than a dollar of precarious income.

Jayamanne: A dollar of permanent capital is worth more because it is supported by favorable tax treatment. There are negative gearing deductions. There are franking credit deductions. When you're looking to sell your capital, you get a tax discount on any appreciation. There's effort that is put into initial investing and maintaining your portfolio, but you will earn income while you are working, while you're sleeping, while you're dining.

LaMonica: Except for you, Shani, because you have no food to eat.

Jayamanne: I wish you just say two meals. Then I could be like, all right, well, let's go out and get something to eat.

LaMonica: You could split one.

Jayamanne: They're very small, so maybe not. Anyway.

LaMonica: Well, back to permanent capital. There's a reason why we use that word permanent capital. It will continue to provide you with income regardless of effort. However, there is depreciation with inflation. If you leave your capital as cash, it will be worth less tomorrow. Your purchasing power will decrease, so you have to ensure that you are putting that permanent capital to work.

Jayamanne: It is up to you whether you find this system unfair, but it is the system. A few elections ago, Bill Shorten lost what was called the unlosable election because he proposed redefining one of the tax advantages, franking credits or imputation credits.

LaMonica: And campaigns have been run around removing franking credits or negative gearing. There are always threats about the removal of capital gain concessions.

Jayamanne: Regardless of how you feel about these issues, it is important for us as investors to plan around the system that we have, but always be prepared for situations to change. The Financial Review put this perspective to most of its older audience when the threat of removing franking credits caused generational rift. It said, a 24-year-old with a massive hex bill and no prospect of owning a house has no sympathy for somebody who enjoyed a free education, affordable housing and full employment, and is now complaining about losing a tax refund even though they pay no tax.

LaMonica: And that's basically the modern day. It's that Asquith quote we talked about earlier, Shani.

Jayamanne: Yes, exactly. So these issues around what some call the unfairness of how different sources of income are taxed will always be there. But regardless of whether you find the system unfair, those that work have little to no tax concessions, but those who build or inherit permanent capital enjoy tax advantages.

LaMonica: And ultimately, as we said, your stance doesn't matter. What does matter is that we make the best of the system we have. It benefits some more than others, but it's open to all to make what they can of it. Use it to better your quality of life and the progress you make towards your goal.

Jayamanne: For many people, this goal is passive income, income that replaces the precarious income that depreciates over time, both blue and white collar, and sometimes just ceases suddenly due to medical conditions, redundancies, or becoming a carer.

LaMonica: Whether stopping work and therefore earning a salary or a wage is voluntary or involuntary, the money to survive from labor is finite.

Jayamanne: So investing serves twin purposes. The fact that precarious income is finite and that financial capital depreciates from inflation. Capital is just capital until you take the steps to make it permanent by generating income from quality investments.

LaMonica: And this leads to the importance of time. Many investors think that speculative investments should be made when you're young, and there is time to build wealth. But this is the time in which you're putting the most permanent capital on the line.

Jayamanne: One of the keys to successful outcomes is time in the market. The duration of time spent with your money invested, and we speak about this a lot, and it's a common theme on Investing Compass.

LaMonica: And this is important for building passive income, because after all, to draw healthy income, you have to have a healthy base of capital.

Jayamanne: So let's go through a quick scenario to show why the money that you make when you are younger is best kept out of speculative investments. So the scenario looks at the monthly savings needed to accumulate $1 million by age 65. The investment earns 7% a year, but the model doesn't take into account taxes, inflation, or transaction costs. We're just keeping this simple to show why it's important to start early.

LaMonica: So with the disclaimers out of the way, when you're 25, you need to save $405 a month to get to $1 million at 65. At 35 years old, it's $855. At 45, it's $1,970. At 55, it's $5,846. You invest in a speculative investment, you are not just losing your capital. It's the opportunity cost of the returns that you would have earned and would have compounded over time.

Jayamanne: If you started at 25, about 80% of your account balance would be based on growth. I would much rather have a consistent small amount going into the market, building a strong capital base than a smattering of success stories, and failures with all the transaction costs in between. The earlier you start, the more of the hard work that has taken off your plate.

LaMonica: Then the easier work becomes as you're able to draw passive income off of a healthy account balance.

Jayamanne: And we really don't want this episode to be purely academic. It's a perspective that we hope will encourage you to either start, continue, or more fervently invest. The concept is simple. Some types of income have more favorable tax treatments than others. It is easier to build wealth with these types of assets and it will contribute to your quality of life as you rely more and more on passive income.

LaMonica: We'll link the article that has all the information that we mentioned, including the table that Shani talked about earlier, that has estimated income that's derived from each asset class, as well as the additions and detractions that bring you to the net income line.

Jayamanne: Also at the end of the article are some links to build permanent capital. The first is an Investing Compass episode that goes through how Mark has structured his portfolio for income. His portfolio goal is to earn and grow his passive income from his portfolio to fund goals such as travel.

LaMonica: There's a link to an article on how to build an income portfolio. It's a step-by-step guide to build a portfolio that generates passive income.

Jayamanne: There's another article that walks through the steps to calculate the amount of capital you need to retire, as passive income is a goal for a lot of people, but especially those in retirement.

LaMonica: And there's one more article. It's an article that goes through the different vehicles that you can invest through as an individual, a company, or a trust. This is because regardless of what vehicle you invest through, in most instances, tax will be involved. Some vehicles have tax advantages over others due to the way that they're structured. You can explore the pros and cons of each vehicle in which you can hold your permanent capital that will distribute your passive income.

All right, so we made it. We talked about Priscilla. You in Sri Lanka reading this book being outraged at the differences in tax rates.

Jayamanne: We're keeping this apolitical, Mark.

LaMonica: And then immediately coming home and saying, well, actually, the guy has a point. I'll just try to invest as much as possible and take advantage of those tax benefits.

Jayamanne: Yeah.

LaMonica: All right, well, that's it. Please don't send me your emails complaining about Shani's view on tax breaks, but I would like an email on episode suggestions or comments that you have. So thank you very much for listening.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)