Time for tax planning

Three days before the end of last financial year I received a call from a journalist from the Australian Financial Review. He was writing an article for publication the next day about tips for managing your tax that financial year.

With tongue firmly in my cheek I suggested my top tip was “to slap yourself in the face for leaving it that late.”

Fortunately he laughed, agreed with me, and also agreed not to quote me.

June is not the time to start thinking about how you will reduce your tax that financial year. Often it is too late to implement the most tax effective strategies.

June is the time for implementing the final tactics of the tax strategy you planned well in advance.

Right now is the time for tax planning

Most Australians are employees so they have reasonably predictable incomes, even when you include investment income and debt.

Therefore your tax position for the financial year can be estimated close enough to give you a good insight into key tax management factors including:

  • Your taxable income
  • Your marginal tax rate
  • Your tax payable
  • Your surplus income after lifestyle expenses

Knowing those factors you can review strategies to decide how you will manage and hopefully reduce your tax.

How to reduce your tax

Tax management should be considered in the broader context of how you manage your money.

The ultimate purpose of managing your money is to ensure you have enough for what you need when you need it.

Yes, reducing your overall tax will increase the money you have.

However many tax effective strategies have significant impacts on your cash flow. Some tax strategies can increase your investment risk way above your risk tolerance and risk capacity.

So tax should not be looked at in isolation. 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.

I have published a detailed introduction to key ways to reduce your tax. Read the article and consider the strategies that may be appropriate to you this financial year.

What you can do right now

My top tips for the tax effective financial strategies you can implement right now include:

  • Salary sacrifice a regular amount to superannuation based on what you have estimated you need to save in order to achieve your financial independence goal
  • Purchase an income protection insurance policy (if you don’t already have one)
  • Contribute a regular amount after-tax to superannuation related to your eligibility for the spouse contribution tax offset and/or the Government co-contribution.
  • Shift your cash savings into the name of the lowest income earner (or better still onto your home mortgage)
  • Submit a PAYG Variation form to your employer considering the expected net taxable income loss from your geared investments (e.g. property). This strategy is better for your cash flow and avoids giving a large loan to the Government.

What you do in June

In June you make tactical tweaks to your strategies. For example:

  • Advise your employer of how much of your anticipated annual bonus you want to salary sacrifice to superannuation.
  • Adjust the after-tax amount you contribute to superannuation that month now you can closely estimate your eligibility for the co-contribution and tax offset.
  • Pre-pay interest on investment loans
  • Self-employed people can make their annual deductible contribution to superannuation based on what they earned that year.
  • Extra charitable donations from your surplus

Guidance on which strategies are right for you

Not sure which tax effective strategies fit your situation and goals?

If you’re in Perth I recommend you attend my next DIY Wealth Creation for Busy People course. You’ll discover how you can strike a balance between spending, saving and tax.

If you’re outside Perth or can’t make the course then call me to discuss financial planning.

How to reduce your tax

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:

  1. Spend money in the production of taxable income
  2. Spend money where the Government wants you to
  3. Give money away charitably
  4. 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.

An example

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
  • Uniforms
  • 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:

  • You
  • 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.

A view of the tax system

A client just forwarded the following parable to me. Have a read and please let me know your reactions in the comments below. The original author is unknown.

Tax cuts in terms everyone can understand

Suppose that every day, ten men go out for dinner. The bill for all ten comes to $100. If they paid their bill the way we pay our taxes, it would go something like this:

  • The first four men (the poorest) would pay nothing.
  • The fifth would pay $1.
  • The sixth would pay $3.
  • The seventh $7.
  • The eighth $12.
  • The ninth $18.
  • The tenth man (the richest) would pay $59.

So, that’s what they decided to do. The ten men ate dinner in the restaurant every day and seemed quite happy with the arrangement, until one day, the owner threw them a curve.

“Since you are all such good customers,” he said, “I’m going to reduce the cost of your daily meal by $20.”

So, now dinner for the ten only cost $80. The group still wanted to pay their bill the way we pay our taxes.

So, the first four men were unaffected. They would still eat for free. But what about the other six, the paying customers? How could they divvy up the $20 windfall so that everyone would get his ‘fair share’?

The six men realized that $20 divided by six is $3.33. But if they subtracted that from everybody’s share, then the fifth man and the sixth man would each end up being ‘PAID’ to eat their meal.

So, the restaurant owner suggested that it would be fair to reduce each man’s bill by roughly the same amount, and he proceeded to work out the amounts each should pay.

And so:

  • The fifth man, like the first four, now paid nothing (100% savings).
  • The sixth now paid $2 instead of $3 (33% savings).
  • The seventh now paid $5 instead of $7 (28% savings).
  • The eighth now paid $9 instead of $12 (25% savings).
  • The ninth now paid $14 instead of $18 (22% savings).
  • The tenth now paid $49 instead of $59 (16% savings).

Each of the six was better off than before. And the first four continued to eat for free. But once outside the restaurant, the men began to compare their savings.

“I only got a dollar out of the $20,” declared the sixth man. He pointed to the tenth man “but he got $10!”

“Yeah, that’s right,” exclaimed the fifth man. “I only saved a dollar, too. It’s unfair that he got ten times more than me!”

“That’s true!!” shouted the seventh man. “Why should he get $10 back when I got only $2? The wealthy get all the breaks!”

“Wait a minute,” yelled the first four men in unison. “We didn’t get anything at all. The system exploits the poor!”

The nine men surrounded the tenth and beat him up.

The next night the tenth man didn’t show up for dinner, so the nine sat down and ate without him. But when it came time to pay the bill, they discovered something important. They didn’t have enough money between all of them for even half of the bill!

And that, boys and girls, journalists and college professors, is how our tax system works.

The people who pay the highest taxes get the most benefit from a tax reduction. Tax them too much, attack them for being wealthy, and they just may not show up at the table anymore.

Pondering taxThis parable is often circulated whenever tax cuts are being discussed and especially when the direction of those tax cuts is being politicised (that’s always isn’t it?).

You can get a sense of the value system of the original author through the parable. But I am interested to hear your view and reactions to the above –  please share them in the comments below (you can do so using “Anon” as your name if you wish.)

If the Henry Tax Review in Australia results in cuts in personal tax rates how should they be applied?

Tax breaks for polluting activities

“Tax breaks for polluting activities should be slashed” according to the Australian Conservation Foundation (ACF) in a media release today. What a fascinating evolution of the increased environmental awareness in today’s society.

Here are a few more quotes from the media release:

“Treasury now estimates that, by 2009-10, we will be spending over $2 billion per year subsidising the use of company cars.”

ACF’s strategies director Charles Berger said:
“These tax breaks are economically senseless, reward environmentally destructive behaviour and increase taxes that the rest of us have to pay. There are much better uses for $2 billion than to hand it out to affluent corporate executives as an incentive to buy cars and drive them as much as possible to get the maximum tax benefit.”

Generally you need to be on the top marginal tax rate and driving at least 15,000kms per year to benefit from salary sacrificing a car in your remuneration package. At current marginal tax rates only people earning over $150,000 per year are on the top rate of 46.5% (including Medicare Levy), which is now a very small percentage of the population.

Plus the significant tax savings come when you drive over 25,000kms per year, so as the ACF claims there is an incentive to drive more to save tax. My anecdotal experience with clients reinforces that view.

What do you think? Should the new Australian Government scrap this concessional fringe benefit (tax break), as suggested by the ACF? Or do you think there remains a genuinely good reason for it to continue? After all if the tax break was scrapped that could mean an extra $2 billion per year available to invest in researching and developing renewable energy.

Let’s open a discussion by leaving your comment below…