Time to tweak the portfolio
By Scott Francis
May 12, 2010
PORTFOLIO POINT: Last night’s budget offered investors plenty of ways to fine-tune their strategies.
Ever since Peter Costello sparked the rush to shovel up to $1 million into super in May 2006, there has been a heightened sense of expectation around budget night.
With the exception of the development a retail bond market, this year wasn’t quite so exciting.
The budget delivered promised tax cuts, unveiled a few unexpected initiatives and showed that perhaps there is more life left in the Henry tax review than we first thought.
The key changes from a personal finance perspective include:
Income tax cuts
- Previously announced cuts to the income tax rate.
- Reductions in the tax payable on interest income.
- More restrictions on the co-contribution scheme.
- Clarity for SMSFs on the tax treatment of instalment warrants.
- Smokers emerge alongside miners as a key tax targets.
Knowing that the cuts were coming has taken away some of their shine but it’s better than having money taken out of your pocket. Two income tax cuts will take effect from July 1:
The value of this is a $300 annual tax saving for anyone earning more than $37,000, and a further $1000 for anyone earning $180,000.
- The 30% tax bracket will kick in at $37,000 rather than $35,000.
- Tax on income between $80,000 and $180,000 will ease from 38% to 37%
This is just the latest in a series of tax cuts. It would be reasonable to ask how well they have been used.
Small tax cuts are hard to notice and easily frittered away, but investors who make adjustments to their investment plans, super contributions and mortgage repayments will reap the rewards over time.
Reduced tax on bank interest
The halving of tax on interest income is an interesting addition to the personal finance landscape. The detail of this announcement is that from July 1, 2011, (effectively the 2012 financial year) investors will be entitled to a 50% deduction on the first $1000 of interest earned from investments such as term deposits and bank accounts.
This is not a huge deal in itself, however in the ongoing battle between interest rates, tax and inflation it will help the average investor while complicating matters for others.
If we assume an inflation rate of 3% and apply the tax rate of 30%, an investor has to earn 4.3% on a cash deposit to achieve an after-tax return of 3%. Most of the time investors can earn more than 4.3% in a cash account. However once they pay tax at the rate of 30% they are left with a return of around 3% which, after adjusting for inflation, is zero.
Another way to look at this is to look at a more average cash rate of return of 7%. After tax at the rate of 30% and inflation of 3%, the real return is 1.9%. If the tax rate is discount by 50%, the real return increases to 3%.
This is hardly earth-shattering, but is better than nothing. It is an incentive for a couple to each have $15,000–20,000 set aside in a cash account, earning an increased after-tax rate of return on risk-free investments. Having a cash reserve set aside to help cope with periods of unemployment, illness or family emergency is an often overlooked strategy, and it just got a little more attractive.
More restrictions on co-contributions
Instead of being indexed, the current income tax threshold of $31,920 for the government’s co-contribution scheme will be frozen for two years. The Treasurer reduced the co-contribution scheme from 150% to 100% in the 2009 budget, which saw the maximum government payment reduced from $1500 to $1000. A sliding scale allows individuals with an income of up to $61,920 to participate.
These amendments are now permanent and are expected to save the government $774 million going forward. The co-contribution scheme has been a popular with couples where one spouse earns the bulk of the household income. However, the government has also allocated $16 million in extra funding to the ATO in an effort to better administer (or police) the scheme.
Clarity for SMSFs on instalment warrants
There has been some confusion surrounding the use of instalment arrangements within SMSFs. Instalments have been a method through which SMSFs geared their investments.
Trustees are considered the owners of a fund’s assets but the use of instalments muddied the waters to the extent that the final payment on a warrant has been interpreted as the trustee taking ownership and therefore triggering a CGT event.
The amendments mean that the ownership of the instalment trust is passed directly to the super fund trustee at the outset.
Smokers to cough up $6 billion
Digging further into the budget papers, the government expects to receive about $6 billion a year in tax revenue from smokers thanks to the recent $2 increase in the price of a packet. The total revenue of the government is $300 billion – so the additional contribution of smokers is 2% of total government revenue.
The NSW Cancer Council website suggests that back in 2007 about 17% of Australians were regular smokers. This minority group certainly seems to be making a very generous contribution to the country’s bottom line. On those figures the average Australian smoker is now expected to contribute an additional $1500 a year in revenue, which might give many another reason to rethink the habit
We’ve previously discussed the cutting of the company tax rate and the 12% superannuation contributions change after the government response to the Henry report was brought down last week (see Reforms and your super).
The tax rate generally increases company profits and dividends while diminishing the chance of receiving franking credits. At the same time the net benefit of a reduction in company tax have been largely offset by the uncertainty of the tax on mining activities for investors in mining companies.
The 12% superannuation contribution increase is also a positive, however these increases are still quite a few years away, so people over the age of about 30 should not rely on them to meet their retirement goals.
However, these proposals from the Henry tax review that were adopted by the government are far from a fait acompli; indeed we can all reasonably expect them to be the subject of much debate in the coming months.
Overall it was hardly a dramatic budget and it certainly lacked the theatre of the last few Costello budgets, but it does prompt investors think differently about a number of topics including:
- Making the best use of the modest tax cuts.
- Employing the use of cash reserve, now that it can earn a more effective return.
- Being aware of new restrictions on the government co-contributions scheme.
- Consider if your SMSF strategy could benefit from the use of instalment warrants.
- Give yourself a $1500 tax break each year by giving smoking the boot for good.
Scott Francis' articles in the Eureka Report