Tax-efficient investing can help you reach your financial goals sooner. By minimising tax on investment gains, you, as an investor, can retain a larger portion of your earnings. As a result, you will receive improved overall returns over time.
Tax-efficient investing can also lead to cost savings due to reduced tax liability. So, in this blog, we will discuss how investment income is taxed in Australia and what some tax-efficient investing options are.
How is investment income taxed?
You must include your investment income in your tax return. This includes the money you have earned in:
- dividends
- rent
- interest
- managed funds distribution
- capital gains
You will pay tax on your investment income at your marginal tax rate. Marginal tax rates for Australian residents are as per the following table:
You are allowed to claim tax deductions for the cost of buying, managing and then selling an investment. However, the Australian Taxation Office (ATO) has set rules around what can and cannot be claimed as a tax deduction when it comes to investment income.
Due to this, investing and tax can be complex for a lot of people. In such a case, a good tax accountant may help.
Making capital gains or losses
Let us understand how capital gains tax works on investment.
Capital gains
You must include all the capital gains made in your tax return in the same year you sold the investment. What are capital gains? When you sell an investment (or an asset) for more than you acquired it for, you have made capital gains.
Capital gains will be taxed at your marginal tax rate. If an investment is held for more than a year (12 months), you will get to enjoy a CGT (Capital Gains Tax) discount. In simpler terms, you will only pay tax on half the capital gain made on that investment.
Capital losses
If you sell an investment for more than the amount you acquired it for, then you make a capital gain. However, if you sell it for less than this amount, you make a capital loss. A capital loss can be used to:
- Reduce capital gains made on the investment in the year the capital loss occurs.
- Carry forward the capital loss to offset capital gains that you may make in the future.
Positive and negative gearing
Positive gearing
Suppose you have borrowed money to invest. The income made from this investment (dividends or rent) is more than the cost of it, including interest and other expenses. This is considered positive gearing.
When you are positively geared, not only do you have extra money coming in, but you also need to pay tax on such income at tax time.
Negative gearing
Negative gearing is when you borrow money to invest, but the investment income is less than the cost of it. Investors, when negatively geared, claim a tax deduction for the investment loss. If you are making an investment loss, it will still cost you money. You will need cash from other sources, such as your salary, to cover the expenses and interest.
Tax-effective investments
Now, let us move on to tax-effective investing and investment options.
A tax-effective investment is when the tax on the investment income is less than the marginal tax rate. Thus, you need to choose investments based on your financial goals, risks you are willing to take on them and expected returns. After this, you shall think about tax benefits.
Superannuation
Super is a tax-effective investment. It is also one of the best ways to save up for retirement. Why? Because the government gives tax incentives to save through super.
The following are included in this:
- A maximum tax rate of 15 per cent on investment earnings in super and 10 per cent for capital gains.
- A tax rate of 15 per cent on employer super contributions and salary sacrifice contributions in case they are below the $27,500 cap.
- No tax on withdrawals from super for people over age 60 (in most cases).
- Tax-free investment earnings when an individual starts a super pension.
Insurance bond or Investment bond
An insurance bond, or investment bond, is a combination of life insurance and an investment portfolio. This is not to be confused with government bonds.
When you purchase an investment bond, your funds will be issued in multiple assets, like property, shares and fixed-interest vehicles.
Any income you earn inside the bond (capital gains, dividends, interest and rent) is not counted in your personal taxable income. The reason behind this is that the bond is taxed internally, and a corporate rate is applied to it, which is 30 per cent.
Another reason why it can be considered a tax-effective investing option is the 10-year rule. As per this rule, after 10 years, the investment bond will become tax-exempt. However, in case the money from an investment bond is withdrawn before the 10-year mark, you will have to declare the earnings in tax return proportional to the time of withdrawal.
On the other hand, if an investor holds the investment bond for a decade or more, earnings from it do not have to be declared as a part of the assessable income with no capital gains tax or additional personal tax applicable.
Company shares that pay dividends
Have you ever bought shares before? If yes, then you must have heard of franked dividends. A franked dividend gives rise to what we call a franking credit or imputation credit.
If an Australian company has made a profit and distributed dividends to investors, franking credits can be used to reduce the tax paid on company dividends. Depending upon the marginal tax rate of an individual, this can lead to a tax refund. However, you must remember that not all shares give rise to franking credits (for instance, international shares).
If a self-managed super fund or an individual has franking credits worth more than the amount of the tax owed, they may get payment from the government for the difference.
Dividends from a company that pays corporate tax at 30% will be considered fully franked. However, not all companies pay tax at full corporate tax rate. Thus, the dividends paid by these companies are called partly franked up to the corporate tax rate paid.
Shareholders use franking credits to reduce the tax they would be subject to paying on income from other sources. Hence, it can be considered a good tax-efficient investing option.
Shares that do not pay dividends
It might come as a surprise for some people, but investing in shares that do not pay dividends can also be tax-efficient. The reason behind this is that these companies invest profits back into growing their business. For instance, take a look at the technology companies around the world. They do not pay dividends but, historically, have generated high levels of capital growth.
Tax-efficient ETFs
If you are looking for some funds that are not only tax-efficient but are consistent performers as well, you should consider ETFs or exchange-traded funds.
Since ETFs track an index, they have low portfolio turnover. Along with this, the investments within ETF are not bought and sold regularly. As a result, ETFs incur lower CGT (capital gains tax) when compared to most active managed funds.
With ETFs, you can also get a 50% CGT discount when held for more than 12 months. Australian share exchange-traded funds can also give rise to franking credits, just like Australian shares.
If an Australian company tax has already been paid by the company within an ETF, the investors do not have to pay tax again at the personal level. The paid corporate tax is passed down to the investors through tax credits. Such franking credits can be used by them to reduce their tax liability.
Investing and tax return
Irrespective of what tax-efficient investing option you choose, you must keep good records to help you during tax time. Records will help you to report investment income and claim all tax deductions that you may be entitled to.
Keeping records will also make it easier to calculate any capital gain and loss when an investment is sold. The following records should be kept when it comes to investments like property, cryptocurrencies and shares:
- Contracts for the purchase of the assets and receipts
- Contracts for the sale of the assets and receipts
- Records of income payments like rental payments, distribution statements and dividend statements
- Receipts for payments made to maintain, manage or improve the investment
You will need to keep the records for 5 years even after including the investment income and capital gain and/or loss in your tax return.
To learn more about tax-efficient investing, reach out to Clear Tax Accountants, where you will get all the information and assistance you need when it comes to Australian taxes.
Disclaimer: The information on this website is for general purposes only and should not be relied upon for making legal or other decisions. The advice provided in this article is general in nature and is not subject to the personal financial situation and needs of any individual. Clear Tax tries to keep the information accurate and up-to-date; however, you should bear in mind with changing circumstances, the accuracy and reliability of the information will not necessarily remain the same. The information is by no means a substitute for financial advice.
