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Six Rules to Cut Tax - Eureka Report Article

May 29, 2006
Six Rules to Cut Tax
By Scott Francis

PORTFOLIO POINT: End-of-financial-year offers might sound good for their quick tax deduction, but superannuation is usually a better bet. Study the long-term benefits before making any decision.

Of course I am minimising my tax, and if anybody in this country doesn't minimise their tax they want their head read because as a Government, I can tell you, you're not spending it that well that we should be donating extra.
— Kerry Packer, 1991 Senate Inquiry.

At this time of year tax becomes a central issue of people's financial affairs. As June 30 approaches there is a growing focus on strategies that they can be used to reduce people's tax liability. Not surprisingly, the number of tax-advantaged investment opportunities suddenly increases, as does the sales pressure that goes with them.

There are three broad categories of tax-planning opportunities. The first use prepaid interest from investment loans or capital-protected equity loans to reduce taxable income. The second use the tax deductions available for agricultural investments to reduce taxable income. The third use salary sacrifice strategies to reduce taxable income. The net effect of reducing taxable income is that a person's tax liability decreases, resulting in a tax refund or a decrease in the amount of tax owing.

At this time of year, when the pressure to make tax-related financial decisions is at its highest, investment promoters have an extra lure for potential clients: the tax benefits of their investment opportunity. The challenge for investors is to keep a long-term strategic focus to their investment decisions rather than getting sidetracked by the lure of a quick tax deduction.

The following six rules and one resolution will keep you on track for this financial year, and see you starting 2006-07 with a clear direction for building wealth in a tax effective manner.

1: Think long term. The tax deduction is not the end game. If you invest your money in such a way that you receive a 100% tax deduction for the initial investment, you are starting with a loss of more than 50% of your money. For example, a $20,000 investment that is completely tax deductible will result in a $9700 tax reduction for an investor at the highest marginal tax rate. This in itself is not a good investment — spending $20,000 to get $9700 back should not make anyone happy. Investors need to look beyond the initial tax benefit to ensure that future investment cash flows will make their investment a success. They should also take into account the tax consequences of these future cash flows, as they are likely to be taxable.

Whether the investment is based on borrowing for investment purposes or an agricultural investment, you should be able to say: "The underlying investments have to produce a performance of X% for my investment to be successful, and this is reasonable because . "

2: Keep superannuation at the front of your mind. An investment promoter offering a "win-win" strategy that incorporates both a great investment opportunity and a tax advantages may be hard to resist. But keep in mind that superannuation can beat that as a win-win-win strategy. The first win comes when you salary sacrifice to superannuation and reduce your taxable income and therefore save income tax. The second win comes when the investment returns from your superannuation assets are taxed at a maximum rate of 15%. The third win comes from the proposed superannuation changes that will see superannuation withdrawals become tax-free for retirees over age 60.

Put simply, salary sacrificing surplus income to superannuation is a highly tax-effective strategy that will be tough to beat.

3: Be honest about what you are investing in. Honesty in assessing a potential investment means accurately categorising the extent to which the investment is speculative, identifying the risks associated with the investment and not getting carried away with forecasts associated with an investment.

Investments that should be categorised as speculative include agricultural schemes with no investment history and geared equity investments that rely on short-term sharemarket returns to provide a positive investment outcome. This does not mean that you should ignore these investments; rather it means that you should acknowledge that they are speculative, and apportion to them an appropriately small amount of your investment capital.

Your assessments of the risks associated with an investment should include:
  • Liquidity risk: The risk that you cannot sell the investments when you need the money.
  • Market risk: The risk that the underlying investment will not perform well enough to provide a positive return.
  • Agricultural risk: The risk that the investment will not produce the yield required to be profitable.
  • Interest rate and cost risks: The risk that your investment will be affected by increases in interest rates or increases in costs.

If an investment does not have a track record and the expected returns are based on forecasts, then keep in mind that forecasting is a difficult business, even for experts.

4: Understand who is earning what from the investment. Knowing the fee structure of an investment and how any adviser is being paid for their advice should be a basic rule for all investing, and it is worth repeating when looking at the investments offered at this time of the year. The judgements that you need to be making with each investment include:
  • What commission is being paid to the adviser promoting the scheme?
  • What fees are the management company making from the investment?
  • What ongoing costs might I have to pay for my investment?
  • What is the underlying rate of interest charged on any borrowing, and is it reasonable?

5: Don't lose sight of the importance of asset allocation and diversification in a portfolio. Gary Brinson, Randolph Hood and Gilbert Beebower, in their academic paper Determinants of Portfolio Performance, published in 1986 in the Financial Analysts Journal, studied 91 large pension funds over a 10-year period. They found that asset allocation was the key driver of investment returns. While agricultural or highly geared sharemarket investments may be appropriate for a small part of any asset allocation, perhaps 5-10%, it would be a mistake to ignore the importance of overall asset allocation in a portfolio and allocate more than this level of capital to these investments.

Ensuring your portfolio is well diversified guards against serious financial consequences if one or two of your investments do not perform as expected. In a year when we have heard stories of people affected from the Westpoint collapse, we should need little reminder of the importance of not putting all of our eggs in the one basket.

6: Keep it simple. Don't overlook the simple tax deductions that you may be eligible for, and have a system in place that allows you to have the necessary receipts available at tax time. These deductions may include work-related deduction, educational expenses, charitable contributions and deductions related to your investing activities. For example, statistics suggest that the majority of investment property owners have never drawn up a depreciation schedule for their property, costing them the opportunity to use depreciation from the property to reduce their taxable income. Givewell, an organisation that encourages charitable giving, uses Australian Taxation Office (ATO) data to show that less than a third of charitable donations end up being claimed as tax deductions.

The ATO website has a list of tax deductions available for specific professions. This provides information on work-related tax deductions that may be able to claim.

Make a resolution

Be proactive and think of tax planning as an integrated and ongoing part of your financial situation. Using the last month of the financial year to try to improve your tax position might lead to a resolution for the new financial year: to start your tax planning for next financial year right now.

Good tax planning should be a core component of your financial strategy, and it can make a huge difference. As a simple example, let us consider a person with $20,000 of surplus income each year on a 31.5% marginal tax rate. If they take $20,000 as income, pay tax at 31.5% and then invest the money into an investment providing a 7% income return, they will have $298,000 after 15 years. If, rather than take the money as income, they salary sacrifice it to superannuation where the tax on the contribution is 15% and the tax rate on investment earnings is 15% they will have $406,000 after 15 years. The only difference is the tax-effectiveness of the investment strategy.

Planning ahead allows you to organise the best salary sacrifice strategy for the year, ensures that you are keeping all the necessary paperwork, keeps your overall investment focus long-term and saves you the stress of having to find last-minute tax management strategies.

* Scott Francis is an independent financial planner based in Brisbane. He has an MBA from the University of Queensland.