14 – Tax planning for investments
Introduction: why tax planning for investments is important
If an investment generating 10% a year is owned by a tax free SMSF the after tax rate of return is 10%. If the same investment is owned by an investor with a marginal tax rate of 45%, and the return from the investment is taxable, the after tax rate of return is 5.5% [(ie 100% minus 45%) of 10%, or 5.5%].
This is a huge difference.
It means a financial planner must consider tax issues such as “who should be the owner?” for every client every time an investment is contemplated.
Table showing effective after tax rate of return
|Earning rate before tax||Tax rate||Type of Taxpayer||Earning rate after Tax “ERAT”|
|10%||0%||SMSF tax rate (pension mode) and personal tax rate up to $18,200||10%|
|10%||10%||SMSF capital gains tax rate|
|10%||15%||SMSF investment income tax rate||8.5%|
|10%||19%||personal tax rate $18,201 to $37,000||8.1%|
|10%||30%||company tax rate||7.0%|
|10%||32.5%||personal tax rate $37,001 to $80,000||6.75%|
|10%||37%||personal tax rate $80,001 to $180,000||6.3%|
|10%||45%||top marginal tax rate $181,000 and above||5.5%|
The ERAT of 5.5% for clients on the top marginal tax rate of 45% is not much: inflation and tax destroy the return on the investment.
Bear in mind the power of compound interest. A difference in earning rate of say 1.5%, ie the difference between the ERAT at the top marginal tax rate of 45% (ie 5.5%) and the ERAT at the corporate tax rate of 30% (ie 7.%). compounded over ten, twenty or thirty years becomes very significant, eventually more than $1,000,000.
This is compound interest at work.
The relative results after fifty years of investing $100,000 at a constant 10% per annum before tax but with different tax rates is shown here:
It is critical that, within the law and subject to the general anti-tax avoidance rules you minimize tax on investment income
You cannot do much about inflation, although avoiding non-growth assets certainly helps. This is why we always recommend businesses, good quality properties and blue chip shares.
The basic idea: structural tax planning
You can do something about tax. Effective tax planning for investments boils down to following three simple rules:
- select investments where the return is either tax-free or concessionally taxed. These include include the home, the practice and the practice premises;
- use tax efficient investment entities, ie spouses, companies, family trusts and SMSFS, to hold your investments;
- maximizing deductible super contributions each year
- integrating the business and the investment structure and
- do not buy and sell investments, instead hold them for the long term, ie decades or even generations, so the (concessionally taxed) capital gain remains unrealized and therefore not taxable (yet).
Following these rules means you and your clients will pay less tax than otherwise would be the case, which means the after tax rate of return will be greater, which means compounding will be stronger and faster.
Tax efficiency if a critical pre-condition for a sound investment strategy.
Further relevant reading
You can read further on tax efficient investing here: The Dover Way. Tax Efficient Investing.
You can read further on tax planning for financial planners here: The Dover Way. Tax Planning for Financial Planners.
You can read an article about tax efficient investing by Simon Blymsa published in the Public Accountant on 30 October 2015 here: Tax efficient investing.