As an investment advisor I am frequently asked how to make tax work for investors. I am not a tax expert but I understand the basics around considering the tax implications of an investment. The first place I start is advising clients that any worthwhile strategy needs to be a sound investment first and any tax benefit should be second.
Some types of investments are more tax effective than others:
- Shares with dividends can help you at tax time.
- Super has tax advantages.
- Managing capital gains and losses needs to be a part of your overall investment plan.
A ‘tax-effective’ investment offers you the ability to pay less tax than you would have paid on another investment with the same return and risk.
What is your Marginal Tax rate?
The first step in understanding how tax affects you is to know your ‘marginal tax bracket’. Put simply, this means ‘If I earn an extra dollar, how much extra tax will I pay?’ Use the Moneysmart income tax calculator to work out how much tax you are paying, or see the ATO website to find out your marginal tax rate.
Understand your investments (Shares and Property)
The Income you receive from investing in shares and property – dividends or rent – will generally be taxed at your marginal tax rate.
‘Franked’ dividends are dividends paid by an Australian company out of profits it has already paid tax on. You will get a credit for the 30% company tax already paid, called an ‘imputation credit’ or ‘franking credit’. This means that a $7 franked dividend is worth the same as a $10 un-franked dividend. If your marginal tax rate is less than 30%, shares that pay franked dividends can be ‘tax effective’ investments.
A capital gain is the profit you make when you sell an investment for more than what you paid for it. Capital gains are generally taxed at a lower rate than other personal income
Your superannuation contributions
The government gives incentives through the tax system to encourage people to save for retirement including:
- Investment earnings are taxed at a maximum of 15% (10% for capital gains).
- Super contributions made by salary sacrifice (up to the contribution caps) reduce your income tax.
- If you are self-employed, you can claim tax deductions for super contributions (up to certain limits).
- Most people over 60 pay no tax on the money they take out of super.
- When you start a super pension, investment earnings are tax-free.
Managing gains and losses
A capital gain is added to your income in the year you sell the investment and taxed at your marginal rate. If you hold the investment for over a year you are only taxed on half the capital gain. So if your marginal tax rate is 37%, your capital gains are effectively only taxed at 18.5%.
Keep a record of any losses you make as they can be used to offset any gains. Capital losses can be carried forward for use in later years. All you need to do is make a record of them in your tax return.
The benefit of this is that when you make a capital gain in future years, you can deduct your loss from the gain.
Watch out for tax drive schemes
Tax schemes generally let you postpone your tax, but you’ll still have to pay tax in the end. They offer tax deductions now for investing in assets that may produce an income in the future.
Agricultural schemes, for example, can take as long as 5 to 20 years to earn any income Look for a clear ruling from the ATO on the tax deductions available for individual schemes.
For more details see the ATO’s guide to understanding tax-effective investments