We get it. You are on a high income, the tax you pay is just as high, and you are looking for ways to reduce your tax. This article will discuss strategies to reduce taxes and build wealth simultaneously.
These strategies are designed for people like you, high-income professionals and executives, and they can save you tens of thousands of dollars each and every year.
Understanding the Different Types of Taxes in Australia
The first step in reducing your total tax is understanding the different types of taxes that apply in Australia. Most people in Australia look at their Income tax and believe that’s all the tax they pay.
That, however, couldn’t be further from the truth. If you are in the highest tax bracket, you are paying 47% (Inc. the medicare levy) on a portion of your income to the tax office.
You might be surprised to hear that is only some of the tax you pay. When you include all the different taxes, levies, and excises we pay – for those on high incomes, the percentage of income handed over as tax increases to well over 65%.
That leaves little to invest with and live the good life.
There are three main types of taxes in Australia: direct taxes, indirect taxes, and capital gains tax.
Direct Taxes
Direct taxes are levied on your income, such as your salary or wages. Even the medicare levy, you could argue, is a tax levied on your income.
All income-producing citizens must pay these direct taxes over a certain income threshold.
Indirect Taxes
Indirect taxes are applied to goods and services you purchase, such as the GST, fuel excise, stamp duty and land tax.
In general, if you abstained from purchasing these goods or services, you could avoid paying these taxes – that’s easier said than done.
Capital Gain Tax
Capital gains tax is a tax on any profits you make when you sell an asset for more than what it costs you to acquire.
Each type of tax has its rules and regulations, so it’s important to understand how each one works and what, if anything, you can do to reduce any and all these taxes legally.
The main takeaway here is that you are paying a lot more tax than you are led to believe.
Review Your Income and Expenses Regularly
An important step in reducing your tax is to review your income and expenses for the financial year. This will give you a good idea of where your money is coming from and where your money is going, and it will help you identify areas where you may be able to reduce your spending and potentially increase your investing.
For example, if you are paying for a gym membership that you never use, it may be time to cancel it and save yourself some money and GST. Reviewing your income and expenses can also help you identify any tax deductions you may be eligible for but are not currently claiming on your income tax.
If you are unsure how to complete this step, we recommend speaking to a qualified accountant or financial advisor. They will be able to help you review your income and expenses and identify any deductions that you may be eligible for.
One of the most important things you can do when it comes to reducing your tax is to keep good records. This includes keeping track of all your income, expenses, receipts, and invoices. This will make it much easier for you or your tax agent to complete your tax return each year and help you maximise any deductions you may be eligible for.
We recommend setting up a system to help you keep track of your records throughout the year.
The point is if you don’t know where your income is coming from and going to, you will never understand what, if anything, you can do to reduce your tax.
Consider Tax-Deductible Investments
Consider investing in assets that are eligible for tax deductions. This includes things like negatively geared investments, managed funds, ETFs and shares.
If you are already investing in assets that are eligible for tax deductions, you may be able to reduce your tax even further by leveraging these investments. Leveraging is using borrowed money to increase your investment return even further.
The process of leveraging allows you two things you wouldn’t otherwise have access to. Firstly, it allows you to compound your returns and increase your return on investment; secondly, it allows you to access your tax to help build your wealth, which is key to effectively increasing your wealth.
You see, the government want you to be self-sufficient in retirement. It is in their interest that you do not go on the pension later in life, and to help you achieve that, they offer incentives and benefits from a tax perspective to people who invest in particular assets to grow their wealth.
Leveraging can be a very powerful tool for building wealth. Still, it also carries some risk, and you should only ever look at leveraging investments when you have a significant cash-flow surplus and are prepared to invest for the long term.
1. Simple Tax Structures
Tax structures can be anything that helps you maximise the amount of tax you have to pay.
If you have a partner, whose name should the next investment be purchased in – your name, their name or both? The answer is – it depends.
For example, friends of mine purchased an investment property in 2018 for $1.2 million and did so without seeking tax advice.
He is the company’s COO (Chief Operating Officer), and she works part-time as an EA, and their income reflects their roles.
He was on $280,000, and she was on $39,000 per annum at the time.
It just so happened that this investment property was cash flow positive to the tune of $20,000 per annum. The difference in tax payable per annum on the extra income was almost double.
From a tax perspective, this investment should have been structured solely in her name, or if this was not possible, he should have had a minority share in the investment at best. Lowering his overall tax exposure to the investment.
If the investment property was ever sold and their income difference did not change, they would also pay a lot more capital gains tax and all because they did not look at the investment property from a tax perspective before purchasing.
Over a 20-year period, if nothing changes in their income, they are looking at paying over $50,000 in unnecessary income tax. If she stopped working, they would stand to lose considerably more.
That’s money that could have been invested into something else.
If the investment was negatively geared, the opposite might hold true, and the investment property would have a greater tax benefit in his name.
Once you enter this agreement and structure, it’s difficult and expensive to unwind.
It’s not as simple as changing a few lines on a document. There’s potential capital gains tax and stamp duty in the tens of thousands of dollars required to make any of these changes.
This highlights the fact that you need someone qualified to crunch the numbers for you. Over time, it could save you hundreds of thousands of dollars in unwarranted taxes.
2. Franking Credits
Franking credits are a great way to reduce your overall tax burden and can even result in a tax refund if the credits are worth more than the tax you owe.
Here’s everything you need to know about how they work.
When a company pays taxes on its profits, it can allocate some of those taxes to shareholders by attaching franking credits to dividends. This is done to prevent double taxation, which can occur when the same income or asset is taxed twice, for example, at the company level and then again at the personal investment income level.
Let’s say Company A pays 30% tax on its profits. If it then pays a shareholder a dividend of 70 cents out of that dollar, the shareholder will also receive a franking credit of 30 cents. This credit represents the tax that Company A has already paid.
When the shareholder goes to file their taxes, they will include the franking credit as part of their income from shares. So if their marginal tax rate is below the company tax rate of 30%, they may actually get a refund equal to the difference between their marginal tax rate and the company tax rate.
On the other hand, if the shareholder’s marginal tax rate is above the company tax rate, they will still only pay taxes on their dividend at their marginal rate minus the company tax rate. This can still result in substantial savings.
To sum up, franking credits can save you a lot of money on your taxes and are definitely worth taking advantage of if you own shares in a company.
The question then becomes, what shares, managed funds, and ETFs provide the best franking credits and growth potential?
3. Trusts
If you’re looking for ways to reduce your tax bill, grow your wealth and secure your financial future, consider using a trust. With the help of a professional, trusts can be an effective way to reduce your tax liability, grow your wealth and protect your assets.
But before you set one up, ensure you understand the implications and seek professional advice.
A discretionary trust might be the way to go if you want to invest in a positive cash-flow investment.
As the name suggests, a discretionary trust allows the trustee of the trust to distribute taxable income to beneficiaries at their discretion. Allowing you to utilise potentially lower marginal tax rates of beneficiaries and reducing the total overall tax liability.
In this example, we have a family of four, two working parents and two adult kids, one in year 12 and one about to start university.
To keep this simple, we create a discretionary trust and purchase high-dividend income-producing shares to the value of $1 million dollars, with a projected net profit of $40,000 per annum in dividend income (approx. 4%).
You could purchase any assets in the discretionary trust, including property and a combination thereof, but for this example, it will be only shares.
Each year, the trustee distributes $20,000 to each of the adult children who are not working and who are attending university and/or school; the beneficiaries pay no tax on that income because of the income tax threshold and low-income rebate (especially if they have no other income for that year).
In effect, saving $18,800 in tax per annum compared to high-income earners.
If the assets are sold before the adult children take up employment, there could be huge savings on the capital gains tax component when disposing of the assets.
Suppose the assets were sold at a profit of $333,332, and that profit was distributed between the two adult children equally. For those who are still not working, the capital gains would be approximately $19,217 each, for a total amount of $38,434 across the two adult children.
If the same assets were distributed to a high-income earner, the capital gain tax would be $78,333 approx.
That is a saving of $39,899 in capital gains tax.
The above structure over a 5-year period could have saved them over $188,399 in total taxes – everything else being equal.
A good financial advisor can help you achieve these types of strategies and structures.
There is a reason why high-net-worth individuals have no problems paying for good financial and tax planning advice. They understand its true worth.
4. Debt Recycling
If done correctly, debt recycling is an excellent way to reduce one’s tax obligation while also growing your wealth. It’s important to get professional help when first starting out and to keep good records of all transactions made.
Debt recycling is a strategy that allows you to turn non-deductible debt like your home loan into tax-deductible investment debt.
But how? I hear you ask.
Let’s say you have a savings plan in place, and every year, you save $50,000 to invest in income-producing shares. Instead of immediately putting the savings into those income-producing shares, you pay down your home loan with the savings, pull that amount back out via an investment loan, and then invest it into the income-producing shares.
In so doing, you make that part of your home loan tax deductible, hence the term debt recycling.
It also allows the power of compounding earnings to start working earlier for you, and it allows you to benefit from dollar cost averaging.
Dollar-cost averaging involves investing the same amount of money at set intervals over a long period, regardless of whether market prices are up or down.
Furthermore, the return from shares/property will generally beat just paying off debt. If you are a high-income earner, you benefit even more from your now tax-deductible debt.
Do this enough times, and you can turn what was once your non-deductible home loan into a tax-deductible investment loan. Affording you all the added benefits of claiming the costs associated with that portion of the loan or all of it (including interest and fees).
If you are considering debt recycling, it’s important to seek financial advice to ensure it’s the right strategy for you and that it is done correctly.
5. Negatively Geared But Cash Flow Positive Investments
Most people are familiar with the concept of negatively gearing an investment. You may have heard it said that someone “negatively geared their investment property”.
That means they are paying more in expenses than they are receiving in rent.
The most common type of expense when owning a rental property is interest on the loan used to purchase the property. Other ongoing costs include repairs and maintenance, council rates, water rates, strata fees (if it’s an apartment), and insurance – to name a few.
When you add all these up, it’s quite possible for the total amount of expenses to be greater than the rent you are receiving.
So, you are making a loss on the property. In Australia, the tax system allows you to use that loss to reduce the tax you pay on your other income.
For example, let’s say as a high-income individual, we earn $220,000 per annum, and we also own a rental property that is negatively geared at $8,000 per year (it’s costing us this every year). Our total annual taxable income is now only $212,000 ($220,000-$8,000).
This allows us to pay $3,760 less in tax. However, we are still out of pocket $4,240 on that investment ($8,000-$3,760).
Let’s add an extra component to the equation, that of depreciation.
When you purchase a newly built property, whether it’s a house, duplex or apartment, in certain circumstances, you can also claim depreciation costs per year.
These costs can be different for each type of property, but for an apartment, it’s roughly $13,000 per annum on average.
This means that our total annual taxable income is now only $199,000 ($220,000-$8,000-$13,000).
After deducting the depreciation from our annual income, the whole investment becomes cash-flow positive.
When we look at the numbers, we are now paying $9,870 less in tax, and the investment is cash-flow positive to the tune of $1,870.
By choosing the right investment, crunching the numbers beforehand, and leveraging tax benefits, we went from the investment costing us $8,000 per annum to being cash-flow positive to the tune of $1,870 per annum.
We are using $9,870 of our tax to fund a negatively geared property that is now cash-flow positive. That’s the power of negative gearing and depreciation.
The average growth rate for property over the last 30 years has been approximately 7%. If we hold that property over a 10-year period, we are looking at a potentially significant capital gain and all the while using our tax to help fund the investment.
A qualified financial advisor will help you understand what is possible and what the final numbers might look like for you.
6. Superannuation Your Secret Weapon
Superannuation is one of the most tax-effective structures available to Australians. The tax on contributions and earnings in the fund is only 15%.
In addition, if you are over 60, you can take advantage of the superannuation pension phase, which means that earnings in the account are tax-free.
This makes superannuation an ideal way to save for retirement. And because it’s a long-term investment, it’s also a great way to build up wealth over time.
Because of these tax benefits, there are some restrictions. You can’t just dump all your savings into superannuation.
Concessional Contributions
Contributions of up to $27,500 are taxed at up to 15% for individuals. This increases to 30% for those earning $250,000 or above. Whilst you are in the accumulation phase (pre-retirement).
Investment income within super is taxed at a flat rate of 15%, and capital gains at 10%.
If your super balance was less than $500,000 on June 30, 2020. Some special rules have been in place since July 1, 2018, for people who don’t use their full allocation of concessional contribution cap, which is $27,500 in the 2022/23 financial year.
You might be able to contribute more than this if you didn’t fully use up the $25,000 cap in 2018/19, 2019/20 or 2021/22 by making some additional ‘catch-up’ contributions.
When you enter the pension phase (when you are retired and over the age of 60), your super fund’s investment income and capital gain tax rate falls to zero (if your total super balance is less than $1.7 million).
When clients bemoan about paying capital gains tax on an investment property they already have, I begin the discussion on how you can actually forgo paying capital gains tax when you purchase property in the right structure.
You can’t get better than a zero-tax rate now, can you?
Non-Concessional Contributions
Most executives I speak to are unaware they can make a $110,000 cash contribution into super each financial year, called a non-concessional contribution.
Because tax has already been paid on this income, you are not charged the 15% tax you normally pay when making contributions.
Depending on your circumstances, this strategy could result in a tax saving of up to 32% on investment earnings within the fund instead of having invested that same amount outside the superannuation fund – and it could help you retire with more and sooner.
Suppose your super balance is less than $1.7 million.
In that case, you may also be entitled to take advantage of the 3-year bring forward rule, which involves pre-paying three years’ worth of non-concessional contributions of $330,000, allowing for even greater savings on taxed earnings.
7. Employee Share Schemes A Hidden Tax Trap
Employee share schemes can become a hidden tax trap if you are unaware of what to look out for. One of the main issues is that most people need to understand that the tax office looks at these share schemes as income received.
Even though they are shares and in any other circumstance, you would not incur a tax event until you sold them. In this instance, you incur a tax event when the shares vest, regardless of if you have sold them or not.
For high-income earners already in the highest tax bracket, this would mean a 47% income tax event on the total cost of the shares when they vest.
In most cases, executives in these schemes must sell part of their vested shares to pay the tax owed.
If the vested shares have appreciated in value, that will also incur a capital gains tax event on top of the income tax event.
As you can see, it can quickly become quite daunting, and it’s best to talk to a financial adviser who can help you navigate this better from the get-go.
Recap
Superannuation
Concessional contributions are taxed at a lower rate than if you were to invest outside of superannuation, and investment income within super is taxed at a flat rate of 15%. Make sure you are taking advantage of the pension phase and the tax benefits that come with it. Most people are unaware they can make a cash contribution of $110,000 into their superannuation fund each financial year.
Trusts: setting up a trust can be a great way to reduce your tax bill. Discretionary trusts allow you the opportunity to distribute income to lower tax-paying beneficiaries.
Debt Recycling
This strategy can be used to reduce the amount of non-deductable debt even faster. You can deduct the interest from your taxable income by recycling it into tax-deductible debt. This allows you to reinvest more of your money and grow your wealth faster.
Franking Credits
Reduce your tax because the company distributing the dividends has already paid the tax on the profits distributed as dividends. So you don’t pay tax twice you receive a franking credit instead. If a person or self-managed super fund has franking credits that are worth more than the amount of tax they owe, they could receive the excess back as a tax refund.
Negative Gearing
This strategy can be used to reduce the amount of tax you pay on your income. You can deduct the interest from your taxable income by borrowing money to invest in income-producing assets. This allows you to reinvest more of your money and grow your wealth faster.
Depreciation
This strategy can be used to reduce the amount of tax you pay on your investments. By claiming depreciation on your investment property, you can reduce the tax you pay even further and, in some cases, turn a negatively geared property into a positive cash-flow property.
Simple Tax Structures
By using simple tax structures, like whose name the investment should be purchased in, you can reduce the tax you pay on your investments.
Employee Share Schemes
It can be a hidden tax trap if you’re not careful. The key is to seek professional advice and understand the tax implications before the shares vest and before you enter the scheme.
Conclusion
There are a number of strategies that can be used to reduce your tax bill. Superannuation, trusts, debt recycling, franking credits, negative gearing and depreciation are all viable options that can be used to reduce the amount of tax you pay every year.
Employee share schemes can be a great way to be remunerated. However, it is important to understand the tax implications before entering such a scheme.
Even simple structures like whose name an investment should be purchased in can greatly impact the tax you pay per annum and the amount of tax you will pay when you sell the asset.
And that’s why it is important to seek professional advice before implementing any of these strategies to ensure that you are aware of the potential tax implications and risks associated with them while considering your financial situation.
By implementing some of these strategies, you could save yourself tens of thousands of dollars in taxes every year. And, over time, these savings can add up to a substantial amount of money.
If you have any questions about tax planning, reducing your income tax or growing your wealth, don’t hesitate to contact me to discuss.
