This week I thought we’d talk about tax. Strategies to minimise tax are often high priorities for those seeking financial planning advice. In this episode we’ll take a look at some of the most common taxes that we as Australians face, pick apart some of the mechanics on how they work, and consider whether it’s appropriate to change anything that you currently do to improve your tax outcome.
Thanks for listening to another episode of the Financial Autonomy podcast, let’s dive into this week’s episode where we talk all things tax.
As always, the information in this podcast is general and doesn’t take into account your personal circumstances. I should also flag that I’m a financial planner not an accountant. Whilst my work has a lot of interaction with tax, I’m not doing tax returns every day and so certainly don’t have the equivalent expertise around the detail that your tax accountant would have.
I want to start by defining what I mean by tax. I’m not just talking about the standard income tax that we all pay. Taxes are more broad than that and include things like council rates, land taxes, fuel excise, stamp duty when we purchase a property, as well as the GST that is embedded into almost everything we pay for. All these taxes are sources of revenue for our governments and provide us with the services that we need.
Taxes are your contribution to the society we get to enjoy. The tax system includes various rules and deductions in an attempt to provide fairness across the system, and in some cases to encourage a particular outcome that is seen as desirable for society. That being the case, it makes sense to have a working understanding of the tax system and use the provisions that have been granted to ensure you pay the appropriate amount of tax. That doesn’t mean paying no tax, but it also doesn’t mean paying more than your fair share.
High Income Earners
When it comes to paying your fair share one myth that I’d like to dispel is the idea that high income earners don’t pay enough tax. Many of our clients are in the top tax bracket and I can assure you that they pay a lot of tax. We’ll dig into the functioning of our marginal tax system shortly, but if you’re drinking from the fountain of low income earners paying too much tax, and high income earners not paying enough, then this is probably not the podcast for you, at least with respect to income tax.
Where there may be a valid argument about unfairness in the tax system is with respect to our capital gains tax system. Capital gains are taxed on the profits you make when you sell an asset that has increased in value. Perhaps you bought some shares or an investment property, sold that asset ten years later, and made a $100,000 profit. Somewhat strangely, you’re only taxed on half of this profit. Quiet why someone who works their bum off all year to earn $100,000 of income has tax applied to that full amount of earnings, yet someone who makes the same money through just sitting on an asset and letting it appreciate in value, pays half the tax has always baffled me. So I think for those who want to get up in arms about inequity, this is an area where they may have a case. Nevertheless, this is the system that we work within and so it makes sense when planning your financial affairs to optimise for accruing capital gains as opposed to generating income.
Our Marginal Tax System
Australia, along with all developed countries as far as I know, uses a marginal tax rate system for personal income tax. This means that as your taxable income rises the amount of tax payable as a percentage of each dollar earned increases. What I find some people get confused with is where the tax rate steps up. So for instance the top marginal tax rate kicks in when your income is at $180,000. At that level of income the tax rate becomes 45% plus Medicare. I sometimes get people fearful of stepping over this $180,000 threshold telling me things like “if I earn more than that it’ll tip me into the top tax bracket”, like that is some sort of disaster. At each tax rate tier, you only pay that higher rate on the dollars above the threshold. So for instance if you earn $181,000 then that top marginal tax rate of 45% is only applied on the $1000 that is over the threshold. Going into the top tax rate threshold does not mean that all the income you earned up to that point suddenly incurs more tax. It’s still the case that even someone earning $200,000 pays no tax on the 1st $18,200 that they earn, 19% on the portion up to $45,000, 32.5% beyond that, and so on.
As I mentioned at the beginning I’m not a tax accountant and I’m not doing individual tax returns so I’m not the one to ask about the detail of tax deductible expenses. But broad-brush, appreciate that expenses are tax deductible where they link to taxable income. So if you own an investment property that is generating taxable income via its rent, then the expenses incurred in running that property, things like council rates and normal maintenance, will be deductible. If you’ve got an expense and you wonder whether it’s deductible, a good basic filter is to think about whether there’s some sort of link to that expense being related to you earning taxable income. Ensure you keep good records, so you don’t miss any potential claims.
I mentioned the property example there. Often one of the largest deductions for someone with an investment property is their interest expense. You’ve borrowed to buy the investment property, that property generates taxable income, and therefore the costs of the loan are tax deductible. Where the costs are greater than the income generated this is known as negative gearing. Negative gearing is not something that’s exclusive to property investment, however because of the ability for high leverage when buying a property, which then leads to significant interest costs, property investment is where you tend to see negative gearing occur the most. In recent years where we’ve seen very low interest rates, negative gearing has become far less common, but perhaps as interest rates rise it might come back again.
Sometimes people come in with the perception that negative gearing is some sort of magical gift, a secret that only a select few know about. In fact negative gearing implies that your investment is making a loss. The amount of money coming in is less than the amount going out. Now the investment overall might still make sense, but it requires that the value of the investment increases over time. A negatively geared investment that does not increase in value is a bad investment, and the chances of tax savings being sufficient to make this bad investment a good one is remote.
Whilst we are in the property investment sphere, another tax to be aware of his land tax. This kicks in at different thresholds depending on which state you live in. It’s an annual tax applied to those owning land. Because it is state based, a strategy can be to spread your investment property holdings across multiple states. You’d need to weigh this up with the downside of less local knowledge, and the reduced ability to monitor and maintain the property.
Land tax perhaps also makes a good case for building your wealth in shares. There’s no equivalent tax for shares.
Our superannuation system is entirely driven around tax incentives. You forgo access to your money until later in life, with the trade-off being that you pay less tax as your money enters the superannuation system compared to had it been paid out to you as regular income, the earnings on those superannuation savings whilst they are accumulating are taxed at a concessional rate, and then when you ultimately retire, you can draw income from these savings with no tax being applied.
When thinking about how to optimise your tax outcome therefore, it’s important to consider how the superannuation system fits into your plans. The ideal end game will be to have a significant portion of your wealth within the superannuation environment beyond age 60. There are limits to how much can be contributed, as covered a few episodes back, so it’s not as simple as just dropping your money into super right at the end of your working life. Good planning is required to build your wealth in this area over time, so as to take maximum advantage of this government endorsed tax haven.
Salary sacrificing is something many of us can access to get an improved tax outcome. When you salary sacrifice, the expense is deducted from your wages before tax has been applied.
The hospital and not-for-profit sectors have particular rules around salary sacrificing that are very generous and if you work in those sectors, you certainly should take some time to understand the options available and ensure you are making the most of them. These salary sacrifice arrangements were granted by government in lieu of pay rises, so they aren’t something you want to just let slip through ignorance.
For the rest of us there’s not that many things that we can salary sacrifice. Superannuation is certainly one. Depending on your role there may also be an opportunity to salary sacrifice for a motor vehicle, although do your sums here and ensure that this makes sense. Sometimes I find that people end up buying a far more expensive car than they otherwise would have, with the result being that the costs are far greater then had they never gotten involved with a salary sacrificed car scheme.
I mentioned before that one advantage shares have over property is that there is nothing equivalent to land tax. Another benefit could be the existence of franking credits. Where you hold shares in companies that have paid Australian tax, and receive dividends from those companies, included with those dividends will be a tax credit to reflect the company tax that has already been paid on these profits. This is a good equitable system that ensures shareholder income isn’t taxed twice, once when the company makes the profit and then again when the shareholder receives the dividend. Of course it doesn’t apply to your international shareholdings. It’s no free lunch. The government isn’t missing out. All franking credits are doing is just avoiding that double taxation.
A common reason for people coming into see us is upon receipt of an inheritance. A common question at this time is whether any taxes are payable either by the estate or by the recipient. The next question is usually whether any taxes will be applied if we gift some of the inheritance to other family members, typically children but sometimes also grandchildren.
The only taxes applicable upon death relate to superannuation. Outside of super, there are no estate taxes in Australia. There are also no gifting taxes, so if you received an inheritance and then wanted to pass some onto your children or grandchildren, that is no problem. The estate might have taxes if investment assets need to be sold which trigger capital gains tax, but that tax would have been payable at some point anyhow.
There is tax payable on superannuation death benefits where the inheritance goes to a non-dependent. This means that superannuation going to your spouse is tax free but when it typically goes down to your adult children, they will have to pay some tax. Taxes are only applied to the taxable portion of your superannuation, and the rate in most cases is 15%.
In the superannuation episode a couple of weeks ago I explained the re-contribution strategy which is a way to minimise this death benefits tax, so that could be something you might wish to go back to.
We are so lucky to be born in a place with quality healthcare, education, a functioning legal system, our roads and infrastructure work, and we can walk the streets safely. All that is possible thanks to the taxes that we pay. So we should never resent paying our taxes, they are what enable the life that we are so fortunate to live.
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