When it comes to tax, all investments are not equal – and savvy investors will seek to invest in a way that optimises their after-tax returns when 30 June rolls around.
This is either done through the structure of your investment, your investment strategy, or both.
The holding structure of an investment refers to how investments are legally owned. ie. do you own the investment as an individual, with another person, or is the investment owned by a company or trust? Depending on how you structure your investments (ie a discretionary family trust could allow you share income with all your family members) you can reduce your individual tax burden.
The investment strategy refers to the actions you take with your investments to get the outcomes you want. For example, you might choose to buy a property that you can negatively gear. Or you might buy shares or ETFs to invest in over the long-term and take advantage of franked dividends each year.
Watch Chris’s video below tax efficient investments, and then keep reading to find out ways you can grow your wealth in a tax-conscious way. We discuss superannuation salary sacrificed contributions, negatively gearing investment property, and claiming deductions related directly to investment income.
Salary sacrificed superannuation contributions
You can either choose to salary sacrifice your pre-tax pay, or make a personal co-contribution from your after-tax income and claim a deduction.
As you can see below, from a tax and super viewpoint, a personal co-contribution has the same net effect as salary sacrifice.
Generally, these contributions are taxed at 15% until you reach your yearly limit, which is lower than even the lowest marginal income taxation rate of 19 per cent. If you’re a high-income earner and pull in over $250,000, you’ll be taxed at 30%. This might seem like a lot, but some other investment strategies can be taxed up to 49%.
Super can be one of the best options around for tax effectiveness, as income earned in super usually has a 15% maximum tax rate, while capital gains are taxed at 10%.
Contributions to superannuation funds are capped at certain amounts and it’s important to be aware of these, or you may end up not minimising your tax liability at all.
Many of the expenses involved in an investment property are tax deductible, including borrowing expenses, interest, advertising, maintenance and agent fees. Losses on your investment can also be offset against your other income, which reduces your tax bill.
Capital gains tax from selling your property can be reduced if you hold on to your investment for more than 12 months, and if you sell during a financial year when your income is likely to be lower.
This strategy is for those wanting to invest in property while minimising tax. It involves buying an investment property where the costs of maintenance (including borrowing expenses, interest, advertising, and agent fees) outweigh your rental income. This loss may trigger a tax deduction and reduces your taxable income.
Meanwhile, as you’re reducing your taxable income, the property is ideally increasing in value over time. However, this can be risky because the property may not appreciate to the degree you would like, and if you’re going to make up for your losses in the end, you’ll be relying on a steadily growing property market.
Additionally, buying and selling property incurs significant transaction costs, so it’s prudent to speak to a registered financial advisor if this is a path you wish to take.
Investment bonds held for 10 years
Investment bonds, or insurance bonds, (not to be confused with government bonds) are a combination of an investment portfolio and a life insurance policy. You can access them via life insurers and friendly societies.
When you buy an investment bond, the financial institution that issues the bond invests your funds in a range of assets, such as shares, property and fixed-interest vehicles. Any income earned “inside” the bond, such as dividends, capital gains, rent and interest, isn’t counted in your personal taxable income. That’s because the bond is taxed “internally” at the corporate rate of 30 per cent.
Another reason investors find investment bonds attractive is the “10 year rule” which means that after 10 years, investment bonds become tax exempt.
Each year, investors can make additional contributions of up to 125% of the previous year’s contributions. Each addition is treated as if it were invested at time of original investment. If the 125% limit is exceeded, the 10 year tax rule will restart.
If an investor wants to switch between underlying investment strategies within an investment bond, there are no CGT consequences. Additionally, ownership can be assigned to another person without tax consequences (e.g. transferred to a minor).
However, if you withdraw money from an investment bond before the 10 year mark, you’ll need to declare the earnings in your tax return proportionate to the time of withdrawal (see table below).
If an investor has held an investment bond for 10 years or more, earnings do not need to be declared as part of their assessable income with no additional personal or capital gains tax applicable – i.e. it becomes tax exempt.
There are no CGT consequences for switching between underlying investment strategies within an investment bond. Ownership can be assigned to another person without tax consequences (e.g. transferring to a minor).
While investment bonds have certain tax advantages, the after-tax returns of investment bonds have been poor in comparison to ETFs. Find out more about whether you should choose investment bonds.
Australian company shares that pay dividends
If you’ve ever bought shares before you may have heard of ‘franked’ dividends. A franked dividend is one that gives rise to a franking credit (also known as an imputation credit).
When an Australian company makes a profit and distributes dividends to investors, franking credits can reduce the tax paid on company dividends. This can lead to a tax refund, depending on your marginal tax rate. (Note that some shares don’t give rise to franking credits, such as international shares).
If a person or self-managed super fund has franking credits that are worth more than the amount of tax they owe, they could get payment from the government for the difference.
If a company pays corporate tax at 30 per cent, the dividends from that company will be referred to as “fully franked”. Some companies pay tax at less than the full rate, and dividends issued by these companies are “partly franked” up to the rate at which they paid corporate tax.
Shareholders can use franking credits to reduce the tax that would otherwise be payable on income from other sources. Companies that distribute dividends with a high level of credits, such as the big banks and Telstra, are particularly popular among self-funded retirees, who seek them out for the sake of both the dividend income and franking credits.
Shares that don’t pay dividends
Investing in shares that don’t pay dividends can also be tax efficient, since those companies are investing their profits directly back into growing their businesses. A good example are technology companies that don’t pay dividends, but have historically generated high levels of capital growth.
Tax efficient ETFs
One of the other reasons we recommend exchange-traded funds (ETFs) for Australian investors is because they are highly tax efficient and are consistent performers.
ETFs have low portfolio turnover because they track an index. Additionally, investments within ETFs aren’t bought and sold regularly. This means ETFs incur lower capital gains tax (CGT) compared to most active managed funds, which constantly trade and lead to higher CGT.
Additionally, where you’ve owned an ETF for more than 12 months, the taxable capital gain will be reduced by 50% for individuals, so tax is only paid on half of the capital gain.
Australian share ETFs and franking credits
Australian share ETFs can also give rise to franking credits, the same way that Australian shares can.
If an Australian company tax is already paid by the companies within an ETF, then investors don’t need to pay those taxes again at the personal level. The corporate taxes paid are passed down to the Australian investor through tax credits (franking credits, as explained above). These franking credits can be used to reduce an investor’s total tax liability. For individuals or complying superannuation entities, any excess franking credits can be refunded at the end of the year if the investor’s tax liability is less than the amount of the franking credits.
Lastly, the dividends investors receive through will only be taxed at their marginal tax rates. This is a big benefit for those on lower tax brackets including self managed superannuation funds (SMSFs).