A desire to reduce tax is one of the key drivers many people list when they initially contact me for financial advice. So today I will share with you my perspective on how you can save tax.
First a word of caution
Only tax accountants and tax lawyers are legally allowed to provide you with specific tax advice. This article is an introduction to some key concepts of reducing your tax from a big picture planning perspective. And of course at the fringes there are some special cases. Start by understanding the key concepts before delving into the fringes.
Speak to your tax accountant for personal tax advice. And if you don’t have one – maybe you should get one as part of your financial team.
Key ways to reduce tax
Four key ways to reduce your tax are:
- Spend money in the production of taxable income
- Spend money where the Government wants you to
- Give money away charitably
- Park your money in a lower tax entity (e.g. superannuation, company, trust, partner’s name)
Note that the first three ways listed above involve you giving away or losing money as a way to reduce your tax.
Key concept: you don’t get everything back
A common misconception is that a $1 tax deduction saves you $1 in tax. That is not correct.
You don’t get everything back.
For an individual tax payer you get back the equivalent of your marginal tax rate. The majority of Australians have a marginal tax rate of 30% (excluding levies). So they get back only 30% of what they spend on deductible items.
You give away $10 to charity. At the end of the financial year you claim the donation as a deduction and the tax on your income is reduced by $3 (what you ‘get back’ when your marginal tax rate is 30%).
Your net cash flow has however reduced by $7. That’s $7 less you could repay off your mortgage, invest or spend.
Spending money in the production of taxable income
Spending money in the production of taxable income is probably the primary source of higher tax deductions and thereby a reduction in your tax payable.
Conceptually you can split it into deductions related to active (personal exertion) income and those related to passive (investment) income.
Save tax on active income
As you may already be aware you can claim some expenses relate to your job, including these common categories:
- Self-funded work-related education
- Some travel
- Some car expenses (not a full deduction as it is subject to some fringe benefits tax)
- Retirement savings (i.e. before-tax contributions to superannuation often through ‘salary sacrifice’)
The Australian Taxation Office (ATO) publishes guides for specific industries and occupations. Check them out to see if there is a guide relevant to you and consult with your tax accountant.
One easy deduction you may not be aware of is that of your income protection insurance premiums. Most insurance is not tax deductible but income protection is because if you later need to claim then the benefit will be taxed as if it was your employment income.
Save tax on passive investment income
In general if your investments earn income each year you can claim a tax deduction for expenses related to those investments, including for:
- Interest paid on money borrowed to invest
- Expenses related to maintaining the investment
In Australia you can also use investment related expenses to reduce your taxable income from your job.
That aspect gets many people salivating so much that they overlook key financial principles.
- If through investing your investment income is higher than your investment expenses you will actually increase your taxable income and pay more tax.
- When your investment income is less than your investment expenses your investment is losing money.
- Your net investment loss may reduce your tax payable on your wages income but you don’t get all of the loss back (remember). So you still have an after-tax net income loss.
- When you’re making a net income loss on your investment you need to make it up in additional capital gain so that overall you get an acceptable return on investment.
Save tax on investment gains
When you sell your investment you realise your capital gain. In Australia the capital gain is included in your taxable income for the year.
You can reduce the tax payable on your capital gain through:
- Holding the investment for over 12 months so that only half of your gain is taxable
- Deducting capital expenses such as transaction costs and stamp duty
- Offset prior realised capital losses
Tax rebates and offsets
The Government really wants you to:
- Keep working and earning money
- Raise future tax payers (so they earn more tax)
- Look after yourself in retirement (so they spend less tax)
So the Government gives you an incentive to do that by rebating some tax to you for ‘expenses’ related to their goals. Current examples include:
- Child care rebate
- Education tax refund
- Spouse superannuation contribution tax offset
Along the way there are other rebates that come and go depending on what behaviour the Government wants to incentivise at the time.
The difference between deductions, rebates and offsets is the way the Government calculates what you ‘get back’.
The key is to stay aware of what is out there and then delve into the detail for those schemes that may apply to how you live your life. Your financial planner and tax accountant are a great help in keeping you aware.
Park your money in a lower tax entity
I believe tax management needs to be looked at broadly across the total tax you pay on all of your money.
In my opinion one of the best ways to reduce your overall tax payable is to reduce the tax rate that applies to the income you earn. Primarily you can achieve this by holding your money in different legal entities, since each class of legal entity can have a different tax rate. (Think of a legal entity as a big tank which can hold financial stuff.)
Examples of legal entities are:
- Your partner
- Superannuation trusts (commonly known as ‘super funds’)
- Discretionary trusts
- Companies (e.g. Pty Ltd and Ltd)
The tax rate for individuals such as you and your partner is based on a sliding scale related to your taxable income. The top marginal tax rate is 45% (excluding levies). As mentioned earlier the majority of Australians have a marginal tax rate of 30%.
Companies pay a top tax rate of 30%, whilst superannuation trusts pay a top tax rate of just 15%.
So the majority of Australians could reduce their total tax bill by investing through superannuation rather than in their own name. Your individual tax payable may not reduce but your total tax will reduce and therefore your net wealth will increase.
Another simple way to reduce tax is to hold your investments in the name of the partner with the lowest marginal tax rate. For example keep your cash savings in a bank account in their name. (Better still keep your cash savings in a mortgage offset account – but that is another article.)
High income earning Australians (those with a marginal tax rate above 30%) could reduce their tax by investing through entities such as companies and discretionary trusts. But the tax saved could be offset by the cost burden of establishing and maintain the entities. Plus there are other really important considerations, which you should first discuss with your advisers.
Putting it all together
As I said earlier I believe tax management needs to be looked at broadly across the total tax you pay on all of your money.
More importantly for most people tax reduction should not be your primary driver in selecting financial strategies. In my experience most people have much bigger financial fish to fry.
The ultimate purpose of managing your money is to ensure you have enough money for what you need when you need it.
Yes, reducing your overall tax will increase the money you have.
But there are some non-tax saving strategies, like repaying personal debt, that will increase your wealth and lifestyle faster, easier and more sustainably. Learn about those strategies too.