Investment tax strategies

Minimising the tax you pay on investments is all about good planning
 
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  • Updated:3 Feb 2006
 

01 .Introduction

Investment-tax-strategies

Tax is a healthy by-product of successful investing and generating a tax bill from your investments means you’re also generating income or capital gains. But if you’re sick of seeing half your profits disappear as tax at the end of the financial year, there are strategies you can use to ensure you don’t pay more than you need to.

  • How can I minimise the amount of tax I pay?
  • What are the most tax-effective ways to invest my money?
  • Should I pay off my home loan or top up my super?
  • Should I make extra contributions to my super before or after tax?

Please note: this information was current as of February 2006 but is still a useful guide to today's market.


It is possible to plan your investment strategy to reduce tax, without taking too much risk. If you’re close to retirement, using a combination of salary sacrifice and undeducted contributions to boost your super can save you thousands of dollars in taxation. New super arrangements provide increased opportunities and improved flexibility for your final years in the workforce.

Younger investors still needn’t look much further than making extra mortgage repayments as a tax-effective way to start investing.

Ways to invest a spare $10,000 in pre-tax income (for an individual on $60,000 pa, 30% marginal rate)

Investment method Undeducted contributions to super Salary sacrifice to super Invested in mortgage ($300,000 loan over 25 years @ 7%) Invest in a term deposit Invest in shares paying fully franked dividends
Tax on income $3000 $1500 $3000 $3000 $3000
After-tax money available to invest $7000 $8500 $7000 $7000 $7000
Earnings rate (a) 7.5% (3-year average for default investment options — net taxes, fees and charges) 7.5% (3-year average for default investment options net taxes and fees) 7% 6% (b) 6.2% capital growth, 4.3% pa income (5 year average from ASX 200)
Earnings in first year $525 $638 Saving of $490 in interest in first year (c) $432 $434 growth in value of shares, $301 paid in dividends, with attached imputation credit of $129
Tax on earnings (d) (d) No tax payable $129 $65 on cap gain (assuming they are sold after 12 months) & $0 payable on income from dividends (e)
After-tax position after 1 year $7525 $9138 (f) $7490 (c) $7303 $7670

Table notes

(a) Returns are based on typical recent performance, and future performance may differ.
(b) Interest paid monthly.
(c) An extra $7000 invested, every year (after 5 years) for the remaining loan term, would shorten a mortgage by around 10 years and save around $150,000 in interest (not allowing for fees).
(d) Tax at 15% is already included in crediting rate and assumes growth within fund is realised.
(e) Growth taxed on 50% of capital gain at 30%, dividends received ‘tax paid’ at 30%.
(f) You may have to pay tax if you take your super as a lump sum or exceed tax-free thresholds and RBLs.

More information
The information in this article is intended to provide you with general information about tax strategies. For more specific answers and questions, the ATO website at www.ato.gov.au has information on all tax topics.

Other bodies that might be able to help include: ASIC www.asic.gov.au ; the National Information Centre on Retirement Investments (NICRI) www.nicri.org.au.

Obtain specific tax advice from your accountant.

 
 

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02.Use Super to minimise tax

 
Money invested through super is locked away (preserved), so it's only an appropriate investment strategy if you're not likely to need it until retirement. It is, however, one of the most tax-effective ways to invest, as any earnings in super are taxed at only 15%, and, you can also use it to reduce your other tax liabilities.

There are several ways to make tax-effective super contributions, and there are benefits with each depending on your super balance, level of income and how close you are to retirement.

In some cases, using more than one method can be most appropriate.

Salary sacrificing

Salary sacrificing out of your pre-tax income has become a particularly worthwhile way to contribute to super. If you're able to, it can be worthwhile to salary sacrifice as far as age-based limits allow.

Table 1: Super age-based contribution limits — for employees

Age in years Contribution limit for 2005–06 ($)
Under age 35 14,603
Age 35 to 49 40,560
Age 50 and over 100,587

Pre-tax income you sacrifice into super is taxed at 15% instead of at your marginal rate. Sacrificing then reduces your assessable income so you pay less income tax, and may be able to lower your overall level of taxation.

For example, if your annual taxable income is $70,000 and you choose to sacrifice $20,000, the $20,000 you place in super is taxed at 15% ($3000 tax payable). As a result your marginal rate drops from 42% (plus the 1.5% Medicare levy) to 30%. Tax saved would be around $3840, but it also means that income from other investments outside super will be taxed at the lower 30% marginal rate (up to the $63,000 threshold when the higher 42% rate applies).

Table 2: Tax rates 2005–2006

Taxable income Tax rate (%) Tax payable (a)
$0–$6000 0 Nil
$6001–$21,600 15 15c for each $1 over $6000
$21,601–$63,000 30 $2340 plus 30c for each $1 over $21,600
$63,001–$95,000 42 $14,760 plus 42c for each $1 over $63,000
Over $95,000 47 $28,200 plus 47c for each $1 over $95,000

Table notes
(a) Plus the 1.5% Medicare levy.

Undeducted contributions

Undeducted contributions are made out of your after-tax income. No tax is paid on the contribution into your super (otherwise 15%) because it's already been taxed as part of your income. Earnings in super still incur tax at 15%, but this is generally better than your marginal rate.

Amounts invested in super in this way don't count towards your Reasonable Benefit Limits (see below) when you withdraw them at retirement, which makes them particularly useful if you're nearing retirement and worried about exceeding your limit.

TIP: Undeducted contributions to a low-income partner's super account can also be eligible for the superannuation spouse tax offset of up to $540.

Reasonable Benefit Limits (RBLs) are the amount you’re able to withdraw from super before marginal tax rates apply. After you exceed your applicable RBL, you will be subject to tax at the highest marginal tax rate if you take a lump sum; or marginal rates if you use your super to purchase a pension. Offsets can help reduce the tax impact if you do exceed the RBLs.

The maximum RBLs are currently $648,946 if you receive your money as a lump sum, or $1,297,886 if you receive at least half of it as a complying income stream (pension). RBLs are indexed every year in line with wages.

Co-contribution

If your assessable income is below $58,000, making an undeducted contribution enables you to take advantage of the government's super co-contribution arrangement. If you earn less than $28,000, the government will pay $1.50 for every $1 you contribute up to $1500. If you earn between $28,000 and $58,000, co-contribution is reduced by 5 cents for every dollar of total income over $28,000.

TIP: if you're able to salary sacrifice to reduce your total income below the $58,000 co-contribution threshold, and then make undeducted contributions, the personal contributions are eligible for the co-contribution payments.

Consider DIY

There is some work and cost involved in running a Self-managed Super Fund (SMSF) but it offers you some additional control over the tax benefits of super.

  • Like other super, SMSFs are taxed only at 15% on contributions, and 15% on earnings.
  • If your SMSF invests in shares that pay franked dividends, and get imputation credits of 30 cents in the dollar, you will get a refund of 15 cents in the dollar of tax paid by the company.
  • Assets purchased after 1999 and held for 12 months (such as shares or property) in a complying super fund are eligible for a one third discount on CGT (they're taxed at 10% of the capital gain as opposed to 50% of your marginal rate outside of super).

Become self-employed and claim deductions

If you're self-employed, or substantially self-employed you may be eligible to claim a tax deduction for personal contributions to super. Self employment is defined as earning no more than 10% of income as an employee, including fringe benefits. While it is not for everyone, you can take advantage of the rules, for example, by salary sacrafice your earnings and live off investment income in one year to do this.

For contributions up to $5000, you can claim the whole amount. For greater contributions, you can claim the lesser of $5000 plus 75% of the excess over $5000 or your age-based maximum contribution limit.

Table 3: Super age-based contribution limits for the self-employed

Age in years Contribution limit for 2005–06 ($)
Under 35 17,804
35–49 52,414
50 and over 132,450

Below the following Tax investment strategies are discussed:

  • Make the most of your home
  • Share franking
  • Bonds and education plans
  • Split your income
  • Borrow to invest
  • Agribusiness or film schemes?

Make the most of your home

  • For most of us, the mortgage is still one of the biggest investments we’ll ever make and thankfully, it’s both tax-effective and provides some of the best returns you’re likely to receive.
  • It’s not subject to Capital Gains Tax if you make a profit when you sell, and if you play your cards right, you can use it to minimise your income tax on other earnings as well.
  • Making extra mortgage repayments can be beneficial, as instead of earning money, in the form of interest, it reduces the amount of interest you pay. Another investment needs to be paying 7% post-tax (or equivalent to your home loan interest rate) to provide the same net return. Very few investments can offer that without exposing you to significantly more risk.
  • Holding extra finances in a mortgage offset account or in a mortgage with a redraw facility (as opposed to a normal bank account) means you maintain flexibility and won’t have to pay income tax on interest that would have been earned. The money also works to reduce the principal of your home loan so you pay less interest.

Share franking

  • Shares can provide both capital growth and income so you may have to pay income tax on dividends and CGT on any profit you make when you sell.
  • You can reduce your end-of-year tax liability by investing in shares that pay fully-franked or partly-franked dividends, where tax has already been paid.
  • Dividends are fully franked if they have been paid out of the company’s profits on which tax has already been paid at the company rate of 30%. They can also be partly franked, where only part of the dividend carries franking credits.
  • Around 52% of companies included on the Australian Stock Exchange 200 Accumulation Index (the largest 200) pay fully-franked dividends.
  • Because the dividends have already been taxed, they will have a credit attached to them that you can offset against other tax liabilities. If your marginal income tax rate is lower than 30%, you will receive tax back, and if it’s higher, you will only be liable for the difference.

Bonds and education plans

  • If you have a long enough timeframe (10 years to get the full benefit) insurance and friendly society bonds offer some tax benefits. During the investment period, the company issuing the bonds pays tax on earnings at 30%, so you receive all earnings at the end of the period ‘tax paid’.
  • Investing through bonds is mostly useful for high-income earners (on rates above 30%), but they’re also useful for people on the 30% marginal rate because earnings don’t have to be declared as income during the investment period.
  • Education savings plans are another tax-effective investment structure. They can provide for your children’s or grandchildren’s education and, if the money is used for educational purposes, you generally don’t have to pay tax on the earnings.

Split your income

  • Income splitting is a useful way for couples to minimise tax and it applies to most investment options, from term deposits and debentures through to shares and property.
  • For simple investments, income splitting is making investments in the name of the person in the lowest income tax bracket. By doing this, earnings will be taxed at the lowest possible tax rate.
  • The opposite can apply if you gear (borrow) to invest. Hold negatively geared investments in the high income earner’s name so you are able to take better advantage of deductions at their higher tax rates.

How does it work?

Peter earns $30,000 pa and Mary earns $70,000. If Peter and Mary inherit a lump sum of $100,000, they’re better off making non-geared investments in Peter’s name so earnings will be taxed at his marginal rate.

That is, if their investments earned them $10,000 and were invested in Mary’s name they would be subject to tax at 42% ($4200 tax), whereas if they were made in Peter’s they would be liable for tax at only 30% (or $3000).

Conversely, if Peter and Mary decided to make a geared investment and were able to claim deductions of say $12,000 for interest or other costs, they would have tax reduced by $5760 if invested in Mary’s name, but only by $3600 if invested in Peter’s.

Borrow to invest

  • You might consider using the equity in your home to fund other investments.
  • You take out a loan using your home as security and purchase other property or shares with the borrowed money.
  • You may be able to borrow without using your home equity, via a margin loan or investment loan. With a margin loan the shares you purchase can be held as security and you may be subject to margin calls. With a loan for an investment property, the actual property is used as security by the lender.
  • The advantage of gearing to invest is that you can offset the costs of investing, including loan interest, accounting costs, bank charges and other related deductions against your other income tax liabilities to reduce your overall tax bill.
  • If your investment costs are greater than your income in a financial year, you’re negatively geared. This is only sustainable if you have enough income from other sources to cover the investment loan repayments and if the capital value of your investments is growing at a rate that would cover your holding costs, inflation, and the CGT payable on the investment when you sell.

TIP:
If you can afford to, paying interest on an investment loan in advance prior to the end of the financial year can enable you to claim for that interest a year earlier than if you wait until after 1 July, so plan ahead.

Consider tenants in common

The way in which you hold an investment property, as specified on the title deed, determines how you must declare any income, and claim for deductions. It can pay to hold the property in one person’s name; or instead of owning it as joint tenants (with an equal share and equal deductions) you can purchase it as ‘tenants in common’, and claim the interest and costs in different proportions according to your marginal tax rates.

Agribusiness or film schemes?

  • Managed investments promoted as being “tax-effective”, such as agribusiness and film investments, have had a shaky reputation in the past but the industry has been cleaned up somewhat is recent years. They ‘re still generally high risk, but can have some tax benefits.
  • Invested money is used for a variety of purposes including specific agricultural schemes (such as growing trees or olives) or film production. Some schemes also borrow to pay for their film or agricultural enterprises.
  • Some schemes have long gestation periods so your returns will depend on the level of activity in the particular market (in olives, for example) five years into the future.
  • Assuming the investment goes well, you can be eligible for deductions as a primary producer if it’s an agricultural investment, or deductions under the film industry incentive scheme if it’s a film investment.
  • The Australian Taxation Office (ATO) advises that for a scheme to provide legal tax benefits, it must have a product ruling. Product rulings are the ATO’s way of letting you know that it has looked at the scheme, and as long as it operates as specified, you will get the available tax deductions (if it doesn’t operate according to the product ruling, you can lose the benefits). It doesn’t assess the likely performance of the scheme.
  • The area is also monitored by the Australian Securities and Investment Commission (ASIC), and companies have to meet the same disclosure, reporting and regulatory requirements as other companies offering financial products.
  • If you’re worried about a scheme that has been offered to you, ATO has a section on taxpayer alerts and information on class and product rulings. You should also ask the company to provide you with a copy of the product ruling for your records, and have it checked by your accountant.
  • As all legitimate schemes have to be registered with ASIC, it should have product disclosure documents, and information about the company should be available on the ASIC website.
  • Remember, taxpayers in Australia are responsible for their own tax returns being correct, so be wary of any advice you receive. Be wary of any scheme which sounds too good to be true, and make sure you don’t invest in anything solely for the purpose of avoiding tax.