Avoiding Costs and Taxes

Written by Kate McCallum, Multiforte

Investment costs and taxes damage your returns more that most people realise.

Let's start with the costs.

Over the past 21 years, the (nominal) gross return on Australian Shares has averaged 7.3 percent per year.
So if you had invested $10,000, you would have a value of around $41,000 today. That’s pretty good, don’t you think?

But it costs money for individuals to invest – particularly brokerage commissions and investment management fees.

A reasonable estimate of these costs is around 2 percent per year. When we take out those assumed investment expenses, the historic rate of net return would drop to 5.3 percent, and the final value would drop by around one-third to just $28,100.

If we assume that as little as 1.5 percent is paid by taxable investors to cover income taxes and capital gain taxes on that return, the after tax-rate of return would fall to 3.8 percent, and the final wealth accumulation would plummet by nearly a half, to $21,000.

Some 50 percent of what you could have earned has evaporated. The wonders of compounding returns have been unrelentingly eroded by compounding costs.

So what can you do?
Minimise investment taxes, the best bet is to maximise your low tax structures – in particular, superannuation and pension funds, and potentially company and trust structures if these make sense for you. The 15 percent tax rate on earnings and 10 percent on capital gains in super will be much lower than the personal marginal tax rates for many investors.

Reduce investment costs. Investment manager fees and trading expenses can place a serious drag on portfolio returns.  If you have a $300,000 portfolio and pay an average annual expense fee of 1.5 percent, it may not sound like much but that's $3,500 coming out of your pocket every year. And that is a significant threat to your long-term wealth building.

Don’t ignore costs and taxes – nor consider them as an afterthought.  If you want to efficiently build wealth, you need to actively protect against anything that threatens to cut a slice out of your growth pie.

Super contributions tax
Many of our clients have asked about the proposed increase in super contributions tax from 15 percent to 30 percent for high income earners. So here’s a brief overview.

The proposed increase will apply to individuals earning more than $300,000.

This only relates to the tax on concessional (pre-tax) contributions – which includes super guarantee payments and salary sacrifice. The tax rate on investment earnings within super doesn’t change – it remains at a maximum of 15 percent.

The definition of income for the $300,000 threshold includes a broad range of income sources including taxable income; all concessional superannuation contributions (both superannuation guarantee charge contributions and salary sacrifice contributions); adjusted fringe benefits; and some foreign income.

The additional 15 percent contributions tax will be imposed personally. The individual has the option to pay the additional tax from their personal cashflow or can request their super fund pay the additional tax on their behalf.

Excess concessional contributions – that is, the contributions that exceed the $25,000 cap – will be subject to the same amount of tax as they are now.  They will remain taxed at 15 percent in the super fund and then again at 31.5 percent to the individual – which is equal to the highest marginal tax rate of 46.5 percent.

Example
Dianne is an executive with a base salary of $240,000. This year, she expects to earn a cash bonus of $50,000. She receives 9 percent super contributions ($26,100). Dianne has no other investments.
Dianne is unsure whether the increased contributions tax will affect her.

Unfortunately for Dianne, she will be impacted by the changes. Her adjusted taxable income will be $316,100, which will take her over the threshold. Compared with the lower 15 percent contributions tax, her additional tax will be $3,750.

Importantly, as the tax rate on excess contributions over the $25,000 cap remains the same, and assuming you stay within the post-tax contributions cap, this is the maximum dollar amount of additional tax payable.

What can you do?
If you are impacted by the proposed contributions tax increase, here are several points to consider:
Where you earn more than $300,000 you are likely to pay personal tax at the highest marginal tax rate. By investing via super you still gain access to significantly lower tax on investment earnings. So, contributing to super remains an attractive option – whether it’s the best for you will of course depend on your goals and personal circumstances.

Where your employer is making super contributions above 9 percent, you could seek to have these additional amounts paid as cash. This way, you have the flexibility to use them for other purposes or to make post-tax contributions to your (or your spouse’s) super.

If your objective is to maximise funds in the low tax super environment, you can elect to pay the additional tax from your personal cash flow.

As you will have excess concessional contributions, you need to be particularly vigilant about making post-tax contributions to super. Exceeding the post tax contributions cap can result in a nasty tax rate of 93 percent.