A new investor's guide to tax
There are a whole host of criteria to go through before deciding to invest.
Is the investment short or long term? Will you need the cash while it is tied up in the investment?
You also need to consider the level of return, the level of risk and whether you are comfortable with that risk, and the type of return, i.e. a steady flow of annual income or a deferred return in the form of a generous profit on sale.
Of course, the tax consequences of a particular investment are important too, but they should never drive your investment strategy. Having said that, it is worth bearing in mind the tax implications - and possibly the benefits - of certain investments.
Generally speaking, all of your investment income needs to be declared in your tax return. This includes:
- Managed funds distributions
- Capital gains from property, shares and cryptocurrencies
You pay tax on investment income at your marginal tax rate however special rules apply to capital gains, which could arise on the ultimate disposal of your investments.
Capital gains and losses
If you sell an investment for more than the cost to acquire it, you make a capital gain. You need to include all capital gains in your tax return in the year you sell the investment. Although capital gains are taxed at your marginal rate, if you've held the investment for more than 12 months, you're only taxed on half of the capital gain. This discount, in effect, can halve the marginal rate that you pay.
If you sell an investment for less than the cost to acquire it, you make a capital loss which you can use to:
- reduce other capital gains made in the year the loss occurs, or
- carry forward to offset future capital gains
Positive versus negative gearing
It's worth bearing in mind the financing options to purchase your investments. If you are borrowing money against an income-producing asset, the interest on the loan becomes tax deductible. That is when we talk about positive gearing and negative gearing.
Positive gearing is where you borrow money to invest and the income from the investment (for example, rent or dividends) is more than the cost of keeping the investment (interest and other expenses).
Negative gearing is where you borrow to invest and the investment income is less than the cost of the investment. Investors negatively gear as they can generally claim a tax deduction for the investment loss. The aim is for the capital growth in future years to offset the loss in earlier years.
Negative gearing can be very attractive from a tax point of view. However, bear in mind that if you're making an investment loss, it is still costing you money. You must have cash from other sources, like your salary, to cover the interest payments on the loan and other expenses.
A tax-effective investment is one where the tax on the investment income is less than your marginal tax rate.
A surprising number of possible investments are very tax-effective but they often come with some significant downsides, such as being very long term, which takes them off the table if you are simply looking to make a quick profit.
Super is a tax-effective investment because the government provides generous tax incentives to save through super. These include:
- A tax rate of 15% on employer super contributions and salary sacrifice contributions, if they're below the $27,500 cap.
- A maximum tax rate of 15% on investment earnings in super and 10% for capital gains.
- No tax on withdrawals from super for most people over age 60.
- Tax-free investment earnings when you start a super pension.
Although very tax-effective (investment income earned by your super fund isn't even taxed on your personal tax return, it's taxed inside the super fund), the downside of superannuation is that you can't (except in very limited circumstances) access the funds until you reach the age of 60 and retire.
Insurance bonds are investments offered by insurance companies. All earnings in an investment bond are taxed at the corporate tax rate of 30%. There are no capital gains tax consequences for switching between underlying investment strategies within an investment bond. Ownership can be assigned to another person without tax consequences (e.g. transferring to a minor).
If you withdraw money from an investment bond before the 10-year mark, you'll need to declare the earnings in your tax return proportionate to the time of withdrawal.
However, if no withdrawals are made in the first 10 years, the withdrawals after that time are tax-free. They can be highly tax effective for investors with a marginal tax rate higher than 30% and an appetite to invest long-term.
Franking credits, also known as imputation credits, allow Australian companies to provide a credit to their shareholders for tax already paid at the company level.
Franking credits can reduce the tax paid on company dividends, or be received as a tax refund, depending on your marginal tax rate. Compared with securities not eligible for franking credits, like international shares, franked securities can help investors reduce the tax they pay. For example, shareholders can use franking credits to reduce the tax that would otherwise be payable on income from other sources such as salary, business profits or rent.
Companies that distribute dividends with a high level of franking credits, such as the big banks and Telstra, are particularly popular among self-funded retirees, who seek them out for the sake of both the dividend income and franking credits.
Many expenses involved in an investment property are tax deductible, including borrowing expenses, interest, advertising, maintenance and agent fees. Losses on the investment can also be offset against your other income, which reduces your tax bill.
Capital gains tax from selling your property can be reduced by accessing the CGT discount if you hold on to your investment for more than 12 months. CGT can also be charged at a lower rate if you sell during a financial year when your income is likely to be lower.
Property is ideally suited to negative gearing, which can have the effect of minimising tax. It involves buying an investment property where the costs of maintenance (including interest and other borrowing expenses, interest, advertising, and agent fees) outweigh rental income. This loss can be offset against your other income which helps to reduces your overall taxable income.
Meanwhile, as you're reducing your taxable income, the property is ideally increasing in value over time. However, this can be risky because the property may not appreciate to the degree you would like, and if you're going to make up for your losses in the end, you'll need to rely on a steadily growing property market.
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