The best tax strategies

Smart Investor, May 2008

Tax time. It polarises people. There are those who coast along with their regular investments without regard for the tax implications. And there are those who become so obsessed with the minutiae of tax avoidance that they forget to consider the rationale of what they’re actually investing in. A course between the two is probably the way to go.

Tax is certainly not to be ignored. “A lot of people we see will ask questions about returns, but will not really understand that tax can leave half your return on the table,” says Darren Johns, a financial planner at Align Financial on Sydney’s Northern Beaches.

But it’s also not to be overstated:  just because something is a good tax deduction doesn’t mean it’s a good investment. “Our rule,” says Johns, “is that if the key attraction to an investment is the tax advantage, it’s not the right reason to invest.”

A falling market has made a bit of a difference to the way people think about tax. In a booming market, people are keen to find any ways to minimise the chunk of their gains that end up with the tax man. In a falling market, people are perhaps more shrewd, or at the very least wary. “Inflows are going to be more on the basis of an investment opportunity than just trying to mitigate tax gains,” says Pia Cooke, who runs a series of tax-effective investment products for Macquarie Bank. And that’s no bad thing.

Still, she sees no shortage of appetite. She’s in the middle of a roadshow touting Macquarie’s Gateway range of capital protected products, and a new one, called a listed protected loan; 2500 advisers are signed to attend. That means you should expect your planner to be putting some tax-efficient products to you in the weeks ahead, so it’s best to be prepared.

Over the next few pages we look at 10 different ways of cutting the tax bill, consider the pros and cons, and give some guidance on what you can save. But don’t forget: make sure it’s an investment first, and a tax dodge second.

1. BUY AN IMA

An independently managed account is like a mutual fund, only you hold the ownership of the shares in the portfolio rather than units in a fund. One of the main advantages of this is tax: when you buy a mutual fund, you might also be inheriting a lot of unrealised capital gains tax issues that you don’t want. An IMA can get around that. “Stock selection is still the most important thing,” says Charles Leyland of Leyland Asset Management, which specialises in IMA structures, “but you can compound that by being smart with the tax side of things.” SMAs, or separately managed accounts, are similar but don’t involve quite the same customisation for the client, since there is still some pooling of decisions on things like corporate actions or dividend elections.

WHAT CAN YOU SAVE? Some shrewd tax thinking in a portfolio might only add 1 or 2% but it all adds up over time

2. DON’T TRADE

It’s tempting in these choppy times to play the markets: pick a trough, buy in, sell out again for a quick buck. But that’s not smart tax thinking. “Trading can seem a good idea in the short term, but when you get your tax bill at the end of the year you realise the implications of that heavy trading,” says Leyland. “Make sure you hold your shares long enough. It’s doing the simple things right.”

Another little thing it’s important to get right: “make sure investments, in particular cash-based investments, are held by the person in the lowest tax rate,” says Paul Moran, a planner and authorised representative of Cameron Walshe in Carlton, Victoria. “It’s the simplest thing, but still people don’t do it.”

WHAT CAN YOU SAVE? Holding a stock for a year halves your capital gains tax compared to flipping it earlier.

3. BUY A LOW TURNOVER FUND

This is part of the same ‘don’t trade’ theory. Some managers, most publicly Vanguard, have argued long and hard that fund returns are only valid if they’re considered on an after tax basis, and the higher the turnover in a fund, the higher the tax cost. Morningstar has found levels of turnover in Australian equity funds ranges from 5 to 150%, and since shares that are held for less than a year pay a higher capital gains tax, that has a big impact on returns.  “Some major funds are on track to hit investors with a double whammy – capital losses and a hefty tax bill,” says Michael Houlihan, Vanguard’s manager of retail products and technical services. Vanguard’s approach is to have low turnover even for an index fund, using what it calls an “optimised approach to indexing”.

A nice theory, but remember a passive index fund can only ever deliver the performance of the market; the best active managers, in theory, compensate by beating it.

WHAT CAN YOU SAVE? Vanguard reckons last year it provided a higher level of growth returns (as opposed to income) than the top 20 Australian equity funds by 14.5 percentage points; the active funds were mainly income, taking a bigger tax hit.

4. TAX SCHEMES

Every year – and particularly at this time of year – you will hear of schemes for investment in forestry, olives, willow and a host of other agricultural ideas which carry a tax deduction. There’s no question some of these are good – and the level of research on them by groups like Aegis has never been higher – but planners do tend to be cynical about them. “I don’t know what kind of an asset class trees or olives are,” says Johns. “Most people I talk to, when I ask how trees or olives are going to help other than with the tax, the conversation usually doesn’t last too long.”

Chris McSwain at RetireInvest in Melbourne puts it like this. “Can you imagine Warren Buffett saying: I’m going to invest in something, I don’t really understand it, I’m not sure about it, and I can’t get out for five years? When BHP is up for sale every day?”

Some, though, think they may have greater merit than that – sometimes. “Agribusiness has certainly matured in the last few years,” says Moran. “It’s become more sophisticated and there appear to be some real investment opportunities as opposed to some virtual investment opportunities in the past.” Moran says that when people research these products, they must make sure they don’t just look at the tax deductibility and the relevant tax rulings, but what’s going to happen to the produce once it’s grown or harvested – who’s going to take it? “It’s all very well to say you’re building a plantation of softwood saw logs, but you have to find somewhere to take the raw timber, not just plant the trees and hope for the best.”

WHAT CAN YOU SAVE: In some cases the whole investment is tax deductible – but it helps if the investment itself delivers.

5. BORROW TO INVEST

When you borrow to make investments, the interest is tax deductible – but remember that gearing carries clear dangers. In a choppy market, fluctuations can put you in risk of a margin call. It’s all about being sensible.

“It’s never that reckless provided you’re sensible with gearing levels,” says Leyland. “If you’re borrowing to buy an investment property, most people will gear up to 90%. I would say 50% over the best companies, a BHP or a Woolworths, is quite defendable.”

One could argue this is an ideal time to gear, with valuations low. “Borrowing to invest is best done when the market is low,” says Moran. He also argues that, since interest rates in Australia appear to be heading up to the top of their cycle, this is in some ways a safer time to do it because there’s less of a risk of considerable hikes in future.

“If you’re going to invest for a suitable timeframe, it’s as good a time as any to borrow to invest,” says Johns. “The flipside is, there are a lot of people trying to manage their margin calls. People who were previously geared up have taken a 30 to 40% bath.”

Post-Opes and Lift, some planners recommend sticking with well-known lenders, and suggest ensuring stock is held in the client’s name, not a nominee. And not everyone is sure it’s time to go in. “Definitely we’re all a bit cautious on gearing,” says McSwain. “I don’t do a lot of margin lending at all.”

WHAT CAN YOU SAVE: the interest on your loan is deductible, and if markets go up you get the benefits of gearing too. But if they go down… 

6. CAPITAL PROTECTION

Products offering capital protection are increasingly popular, and tax effective too. They lock you in for a certain time, guarantee at least your money back if you hold it to term, and the cost of the interest is deductible. They divide opinion, though.

“Advisors I’ve spoken to in the last few months who invested last year, the capital protection feature has given them more sleep at night,” says Pia Cooke at Macquarie. But Leyland calls capital protection “expensive insurance. You’re better off holding money until you’re more comfortable and going in at a lower level.”

Most capital protected products come with a loan built into them, in which people borrow as much as 100% of the value of the investment. “There’s an interest cost and a capital protection cost,” says Moran. “It implies that the investment has to produce returns in excess of, typically, 14% in order to break even. That’s an above average return for the share markets. I don’t think it’s reasonable to take a five or 10 year investment where you assume it’s only going to work if it produces above average returns.”

Cooke doesn’t agree with those maths. “If I want to get a 100% protected loan over CBA right now, it might cost 17% in interest, but I can claim 14.15% against tax [capital protection can be claimed up to the unsecured lending rate, currently 14.15%, but not above it]. If I take into account the dividend yield, my annual break even may be as low as 3 to 4%.”

Macquarie is now launching what it calls the new generation of protected loan products – one that’s listed, with the ability to walk away from it, with the same liquidity as any warrant. We’ll take a look at that next month.

WHAT CAN YOU SAVE? Protection is deductible up to 14.15%; also you’re not going to lose your investment since it’s guaranteed.

7. PUT IT IN SUPER

The obvious one – and still a good decision. “Superannuation is as tax attractive as it has ever been,” says Darren Johns. “Although the government hasn’t reduced any of the contributions tax, they have taken away the confusion and complexity, such as RBLs and so forth. More money is going in than ever before.”

Advisors gripe about the low limits on contributions that qualify for tax benefits – for people aged over 50, it has actually declined, from $105,000 to $100,000, though below that age it’s increased to $50,000 – but it’s still one of the best deals in the country. “People are starting to wake up to it finally, after about a decade,” says Moran. “I get the same tax deduction as if I go into an agribusiness scheme. Putting $25,000 into a timber scheme to get a tax deduction is exactly the same as putting $25,000 into super, but I can see and manage it myself.”

McSwain says a large part of what he does is “getting people out of the mentality of paying high rates of tax and putting money in the bank, and trying to get them to put a lot more into super. It’s a really easy game.”

WHAT CAN YOU SAVE? Money that you could be paying 46.5% tax on is instead taxed at a maximum 15%.

8. PAY IT FORWARD

For many people, there are advantages to prepaying interest or other deductible expenses before June 30. “You can prepay 12 or 13 months of bona fide tax deductible expenses and claim them this year,” says Johns. “It’s just about deferral – we’re all going to pay our dues – but you can stagger the timing and minimise the impact.” The same goes for deferring a big sale such as a property or a business to after June 30. Or making deductible contributions to super: someone over 50 with $200,000 to put into super can put half of it in on June 30, half on July 1, and have the whole lot deductible; they could then use the money to start a tax-efficient pension.  

Separately, it is worth talking to a surveyor about identifying depreciation schedules on any investment properties you own. “A lot of people don’t claim depreciation and some can’t,” says Moran. “But for some people it can make investments more tax effective.”

WHAT CAN YOU SAVE? Nothing really – you’re deferring rather than avoiding – but there is an opportunity to do something with the money you’re hanging on to in the short term. For  depreciation, the rate in Australia is 2.5% a year starting from construction.

9. GIVE IT AWAY, GIVE IT AWAY NOW

If you’re thinking of donating, or generally divesting yourself of money, “it can be more effective to do it while you’re living and earning tax than later on in life,” says Johns. If you make a donation through your estate after your death, there’s no deduction. If you do it when you’re not earning, there’s no income, so it’s not as tax friendly. “Much better to do it while you’re a tax paying person,” he says.

WHAT CAN YOU SAVE? It’s more what you can give.

10. TAX EFFECTIVE BONDS

Some promoters offer bonds which, if held for long enough, bring tax advantages too. An example is ING, whose tax-effective investment bond features a maximum income or capital gains tax of 30% provided you make no withdrawals within a 10-year period (you’re also not allowed to make contributions in any one year which exceed 125% of the value of the previous year). It’s not subject to the preservation age in the way super is, so it’s an effective way of saving tax efficiently for early retirement, since you’re not subject to the minimum age of 55 that applies to access your super. It also allows you to nominate anyone you like as a beneficiary, unlike super’s requirement that it be a dependent. “It’s very useful for estate planning,” says David Kan, executive director at ING. $160 million went into this product in 2007 alone; only makes sense, though, if you’re on a high tax rate.

WHAT CAN YOU SAVE? Whatever you put in is taxed at 30%, so you save whatever the difference is between that and your personal tax rate. 

CASE STUDY

Michael O’Connor quit his job at the NAB a few years ago. “I’d been there 36 years,” he says, “and when they asked for volunteers, I put my hand up.” He took a year out, got a pilot’s licence, went to see his son in America; now, he manages body corporates, in a job with less income and less stress than his old one. In a lifetime of hard work at a bank he’s provided well for himself, and has about a million dollars accumulated in super. He’s 55.

These days, his wife, Jan, is the main earner for the family, with a big job at Westpac earning around $200,000 a year. She’s a little younger than Michael – 51 – and plans to keep working a while yet.

So here’s their situation: Jan has been paying a fortune in tax, and Michael, since his retirement, much less so. Also, Michael, who turned 55 in July, has hit the age at which he can begin drawing down some of that pension. So, together with financial planner Chris McSwain, proprietor of RetireInvest in Hawthorn, Victoria, they devised a plan to take advantage of the recent flexibility added to superannuation access.

It’s very simple. Michael has taken some of his super and shifted it to a pension, enough to give him $3000 a month net to live on. Meanwhile Jan is now salary sacrificing $60,000 a year into super. Consequently she’s earning a lot less to be taxed on. And what a result. “We’re effectively saving $25,000 a year in tax,” says Michael, “and we’re cashflow neutral.”

Over the four years until Jan turns 55 and is likely to retire, she will put over $200,000 into super and save $100,000 in tax. By then, Michael will be 60 and able to draw on his super as much as he wants without tax.

“It’s just taking advantage of simpler super changes,” says Chris McSwain. “It took about a year to put in place but they’ve saved a bunch of tax.”