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How can I invest tax-effectively?

This article this was first featured in Adviser Ratings. View the original here: https://www.adviserratings.com.au/news/ask-an-adviser-tax-efficient-investment-strategies-for-small-business-owners/

Broadly, the amount of tax payable on an investment will be determined by three things:

  1. How much you earn from the investment
  2. The type of investment return, and
  3. What rate tax needs to be paid

How much you earn

How much you earn is pretty straight forward. The more you earn, the more tax you pay. However, you can reduce this by ensuring you are claiming all deductions your eligible for, a qualified accountant will be invaluable here.

A good example of how maximising deductions can work is negative gearing with property. When the expenses of owning the property exceed the income received, the loss can be deducted against your other income, thereby lowering your overall tax liability. The downsides are anytime debt is involved in an investment, your risk increases and you’ll need to cover any cashflow shortfall of the investment.

Type of returns

This means, are your investments generating income (interest, dividends, rent) or capital growth? Income will be taxed at the relevant tax rate in the year it is received. With dividends, some of the tax might be paid already for you through franking credits.

However, with capital growth, you are only taxed when you sell. This gives you more capital that can compound along the way and if you’ve held your investment for at least 12 months, you can typically reduce how much is taxable by 50%.

Because of this, investments that favour capital growth, such as shares and property, will likely be more tax-effective than investments that favour income like bonds and term deposits.

What tax rate needs to be paid

The rate of tax payable on your investment is going to be determined by ‘who’ owns it. Below are a few common options:

  • Superannuation: For most people, this is your most tax-effective option. You can make voluntary contributions to your superannuation and claim a tax deduction for them and only pay a 15% contribution tax (compared to your marginal tax rate personally). The earnings in super are also then only tax at 15% which helps your investment compound faster. Then when you retire, you can move your super into a tax-free environment to help support you. The downside is that you can’t access these funds again until you meet strict conditions of release like reaching your preservation age.
  • Individual ownership: This is the most straight forward option and involves owning the investment directly yourself which also keeps ongoing cost and complexity minimal. However, the downside is investment earnings will be taxed at your personal marginal tax rate which can be significant if you’re on a higher income.
  • Spouse: This is similar to individual ownership but if you have a spouse on a lower tax bracket than by holding the investment in their name, earnings are taxed at their lower marginal tax rate.
  • Investment bond: Investment bonds are a great option when your marginal tax rate is above 30% because that is their maximum tax rate. Additionally, they are ‘internally’ taxed which means none of the earnings need to be reported on your personal tax return. Unlike super, you can access your investment at any time and withdrawals are tax-free after 10-years. Investments may also offer protection from creditors in the case of bankruptcy which can be pretty important for small business owners.
  • Your business: As a small business owner you may be able to take advantage of the small business capital gains tax (CGT) concessions. If you’re selling a business asset, you may be eligible for CGT concessions, which can significantly reduce or eliminate the tax payable on the capital gain. As common example is purchasing your own commercial premise.

As with any investment strategy it will be important to consider why you are investing, what level of risk you are willing to accept, and what your timeline is. This will help determine what you should invest in and how you should invest.

A good financial adviser will be able to help you navigate these areas and it’ll be vital that you, your adviser, and accountant are all on the same page to ensure you get the best outcome.

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