Clean up with carbon tax

By Scott Francis July 15, 2011

PORTFOLIO POINT: Get ready to make the most of the new tax scales from July next year.

A key part of the government’s clean energy plan – or carbon tax – are the considerable adjustments to the tax-free threshold that will be used to compensate those on lower incomes for paying higher prices.

These changes allow smart investors to structure their affairs to create significant tax advantages, so it’s important that we consider these possibilities to be ready for July 1 next year, when the changes become law.

Not too long ago, I wrote an article explaining how by not indexing the tax-free threshold the government was creating a nice little earner for itself. After reading this article and considering the strategies it contains, I hope you find a way to out away a few extra dollars for yourself.

How tax scales will change

By looking at the proposed changes, set out in the table below, it is evident that the jump in the tax free threshold is, to some extent, occurring at the expense of the higher tax rates in other brackets. But before we move on, it is important that readers have a strong understanding of the term “marginal tax rate”, so bear with me but it won’t take long.

A person’s marginal rate is the amount of tax they would face on the next dollar that they earn. For example, a person on $60,000, about the average wage, pays 30% tax (plus 1.5% Medicare levy) on every extra dollar that they earn. If, for example, they were to earn an extra $1000 they would lose $300 – or 30% – income tax.

This is important in considering these new tax scales. The increase in the marginal tax rate to 32.5%, and then to 33% by 2015, means most people earning between $18,201 and $80,000 (where the 30% tax bracket ends) are now facing a higher marginal tax rate – albeit with a much more generous tax-free threshold.

So if a person can reduce the amount of income that incurs the higher marginal tax rates, while still taking advantage of the more generous tax-free threshold, they should be able to improve their financial position. There are four strategies that we will look at today:

Negatively gearing an investment. Salary sacrificing to superannuation. Keeping cash investments inside superannuation. Using opportunities to “split income”.

It should be noted that these strategies are all valuable now; they will become more valuable under the new regime with a much higher tax-free threshold and higher marginal tax rates.

Negatively gearing an investment

Borrowing to invest is a strategy that should be treated with caution: when investment markets fall it has the potential to destroy large amounts of wealth.

The traditional “negative gearing” opportunity – where the costs of an investment are higher than the income and leads to a loss that decreases a person’s taxable income and tax paid – relates to an investment property. Let’s consider a person who earns $60,000 a year under the current tax rates. They would pay income tax of $12,450.

If they bought an investment property that provided income of $15,000 a year, with expenses (mainly the interest on the loan) of $25,000, it is interesting to consider their revised tax situation under the tax scales that start from July next year.

They will make a $10,000 loss on their investment property, which will reduce their taxable income to $50,000, of which $18,201 – more than one-third – is tax-free. The total tax they will pay will reduce by almost $4000.

This is a significant tax saving, but it should be noted that the overall strategy will only be successful if the underlying assets increase in value.

Salary sacrificing to superannuation

To demonstrate the increased effectiveness, let us consider a person who again is currently earning $60,000 a year, and salary sacrifices $15,000 to superannuation. This leaves them with taxable income of $45,000. They will currently be paying $9,975 of tax, being:

Income tax of $7050 on their taxable income of $45,000. Medicare levy of $675. Superannuation Contributions Tax (15%) on the $15,000 salary sacrifice of $2250.

In the 2012 financial year this same strategy (salary sacrificing $15,000 of income to superannuation) will see that person’s income tax fall from $7050 to $6172. The Medicare levy and superannuation contributions tax will stay the same, so the overall tax saving will be $878 or about $17 a week. This may not sound like a particularly dramatic figure, but keep in mind that this is the tax saving based on exactly the same strategy.

Moving cash investments into superannuation

With the tax rate for an investor who earns an average income increasing from 30% to 32.5% (plus the 1.5% Medicare levy), it becomes more difficult for an investor to hold a cash-style investment in their own name and expect a return better than the rate of inflation.

Currently a reasonable cash account will provide an investor with a return of 5.5% (although there are some with higher returns). For an investor with a marginal tax rate of 32.5% plus the 1.5% Medicare levy, the after tax return is 3.6%. This compares relatively unfavourably with the same cash account held in a superannuation fund providing an after tax return of 4.7%. This might be a particularly attractive strategy as people approach retirement, where they are able to access cash assets held in superannuation.

Income splitting

The final strategy is one that will be important for couples deciding where investments outside superannuation should be held. Consider a couple, where one is earning $60,000 and the other is earning $12,000 from part-time work. They receive a lump sum of $40,000. They want to invest in shares paying fully franked dividends of 4.5%. This will mean a dividend of $1800 with franking credits of $771. If this is invested in the name of the higher earner, under the proposed new tax rates they would have an after-tax dividend of $1697. If this is invested in the name of the lower earner, there would be no tax paid and the franking credits would be received as a tax refund – meaning an after-tax dividend of $2571.

It’s important to remember that none of these strategies are new; it is just that they have a new lease of life as Australian taxpayers try to adjust their personal finance strategies to benefit from a tax-free threshold that has tripled, while trying to avoid an increase in the 15% and 30% tax brackets.