7 ways to hit the new year running
By Scott Francis
June 30, 2010
PORTFOLIO POINT: Not all wealth creation strategies are created equally, as the following exercise shows.
The new financial year is the perfect time to make some resolutions. But before you make a commitment to saving more, salary sacrificing or starting a transition to retirement scheme – wouldn’t you like to know which strategy is the most effective?
Today we rank seven wealth-creation strategies ranging from the very basic to the more sophisticated. The results might surprise you.
We’ve assumed that the investor has made a commitment to setting aside $100 a week after tax to improve their financial situation with the intention of sticking to it for at least five years, and generated the results using ASIC’s own online calculators.
The seven strategies we look at are:
The unlabelled graph below shows the financial impact of each of the strategies on over five years. Read on to find out which is which.
- Using $5200 a year to build up a cash reserve.
- Investing $5200 a year into growth assets.
- Putting $5200 towards reducing high-interest debt.
- Making $5200 in additional mortgage payments.
- Salary sacrificing the equivalent of $5200 in income into super.
- Depositing $5200 into a first-home savers account.
- Starting a transition to retirement income stream with $5200 in surplus income.
Building a cash reserve
Having a cash reserve is a great way to ensure that you are able to withstand unexpected costs, take advantage of dips in the sharemarket and offset your mortgage (for more on cash, see Bruce Brammall's feature today). Thanks to the 50% reduction in the tax rate for the first $1000 of interest earned from June 2011, they just got even more attractive.
If we assume an after-tax return on a cash account of 4.5%, $100 a week over five years will provide a financial reward of $29,272 – a nice cash reserve that will help deal with unexpected situations. Importantly, this is also a "risk free" strategy: interest rates might vary a little, but you know that at the end of your five years you will end up with close to $30,000.
Investing in growth assets
The case for investing in growth assets such as shares or property is that over long periods (usually taken to mean 15 years or more) they have reliably provided higher returns than cash. The big difference between growth assets and cash is that the return from growth assets is risky, especially over a relatively short time period like five years.
Acknowledging that, if we invest $100 a week into growth assets over five years and assume a return of 10% we arrive at $34,921. Of course, suggesting that we can invest $100 a week into an investment property is not completely practical; however, what this exercise does is provide a rough guide as to the earning power of growth assets in comparison with others.
Reducing high-interest debt
Most Eureka Report readers are well past battling high-interest debt from credit cards, but it is instructive to know just how effective it can be to make additional payments to debts of this nature.
Extra debt repayments effectively "earn" the interest rate applied to the outstanding debt. For example, if a credit card is attracting an interest rate of 18%, then extra repayments are saving/earning the debtor that 18% interest. The saving is also tax-free and a return of 18% is as good a return that you will find anywhere, which is why it is such a good strategy.
Directing $5200 a year over five years to a debt with an interest rate of 18% will improve a person's financial position by $40,319. This is effectively a risk-free return.
Additional mortgage repayments
One of the bedrocks of financial wisdom over time has been that making extra mortgage repayments will save you time and money. This still makes sense, and in some ways makes more sense than ever as people battle bigger mortgages than ever before.
With the average variable interest rate of about 7.25% at the moment, five years worth of making an extra $100 a week of mortgage repayments (again effectively earning a tax-free and risk-free return of 7.25%) will improve a person's financial position by $32,232.
There is a sneaky benefit from this strategy in that $5200 a year after tax is leveraged by the tax saving from a salary sacrifice to superannuation strategy.
If we consider $7591 in pre-tax income essentially becomes $5200 after accounting for tax and Medicare charges of 31.5%, the benefits of investing pre-tax income via salary sacrificing become quite clear. Superannuation attracts a tax of just 15%, which means instead of investing $5200 in after-tax income we can put $6453 to work inside super.
Working on the assumption of after-tax earnings of 7.5% annually then the benefit at the end of the five years is $38,737. Some of the return is risk-free, the tax savings from choosing to salary sacrifice. The 7.5% annual return contains the various risks one normally encounters when investing in a mixture of income and growth assets.
First-home savers account
The first-home savers accounts are based on an individual contributing up to $5000 a year, with the government adding a further 17% to the account. The maximum extra contribution in any year is $850. This is the amount that would be added if the $5200 a year is contributed to a first-home saver account, possibly to help a child or grandchild purchase their first property.
Assuming an earning rate in the first-home saver account of 4.5% a year, the $5200 annual contributions, boosted by the government contributions of $850 each year, will take the balance of the account to $34,587 – a nice reward for a commitment of just $100 a week.
Starting a transition to retirement income stream
In my opinion this is the ultimate personal finance strategy for anyone over the age of 60, and possibly 55 – depending on the components of your superannuation fund. The figures speak for themselves. There are three impressive forces working for you with this strategy:
1. You are withdrawing money tax-free from your superannuation fund.
2. You are saving on tax paid through salary sacrificing to superannuation.
3. The earnings in your superannuation are now taxed at 0% rather than the usual 15%.
Let's put some figures on these savings for someone who is 60 years old with $267,000 in their superannuation fund.
First, if this superannuation fund is converted to being a pension fund the earnings on the fund are now tax free – a saving of at least 0.75% or $2000 a year. Second, let’s assume they withdraw $20,000 a year tax-free from the superannuation fund to help meet their living costs.
A person paying tax at the rate of 31.5% (30% tax plus 1.5% Medicare) has to earn $29,200 to end up with $20,000 after tax – so this amount of money ($29,200) can now be safely salary sacrificed to superannuation. This leaves $24,817 after the superannuation contributions tax of 15% – which is the equivalent to a tax saving of $4871 a year.
Finally, we have the $100 a week surplus to salary sacrifice to superannuation. Because of the tax saving we achieve through salary sacrificing to superannuation (15%) compared to an income tax rate (which we have assumed is 31.5%) this adds up to a substantial $6,453 a year.
The total annual benefit is:
$2000 tax saving for the superannuation fund in pension mode.
$4871 tax saving through the salary sacrifice of $29,200 of income to superannuation made possible through $20,000 in tax free income from superannuation.
$6,453 from the salary sacrifice to superannuation of the $5,200 after-tax income.
Usually a person who uses a transition to retirement income stream will roll their superannuation into their pension fund every year. If we assume the pension fund has an earning rate of 8.25%, then the total benefit of this $13,342 every year will end up being $85,153 after five years.
The significant tax saving from the superannuation fund in pension phase, and the ability to save significant amounts of tax through salary sacrificing makes this a lucrative strategy. And, while the earning rate of 8.25% a year is not risk free, the rest of the strategy is.
To be fair to the other strategies, there is a lot more at work here than just a surplus $100 a week – however the $100 a week plus a transition to retirement income stream is proven here to be an extremely effective strategy.
Not all personal finance strategies are not created equal – and many people will use a mix of all six of these strategies at different times in their life.
However a focus on choosing the most appropriate strategy at the most appropriate time, along with the discipline of directing $100 a week to that strategy, has the ability to make a meaningful difference to most people's financial situation over the relatively short period of five years.