There are not many certainties in personal finance, or life for that matter. However, one thing that is for certain is taxes. For individuals in Australia our tax system is progressive which means that individuals with higher taxable incomes are required to pay a higher marginal tax rate. We observe this through the current individual income tax rates increasing as the taxable income backets rise.
| Taxable income | Tax on this income |
| 0 – $18,200 | Nil |
| $18,001 – $37,000 | 19c for each $1 over $18,200 |
| $37,000 – $90,000 | $3,572 plus 32.5c for each $1 over $37,000 |
| $90,001 – $180,000 | $20,797 plus 37c for each $1 over $90,000 |
| $180,000 and over | $54,097 plus 45c for each $1 over $180,000 |
How income tax is calculated
The Australian tax system is a specialist field that warrants its own set of encyclopedia volumes however, for individuals, it is essentially calculated by determining taxable income and applying the appropriate tax rates as seen in the table above. The medicare levy of 2% is then applied on top of the tax rates stated above. Taxable income is calculated using the following formula:
Assessable income refers to items like wages; interest from bank accounts; rent; pensions and commissions. Allowable deductions are items like portfolio management costs; interest paid on deductible debt; and work-related expenses (ATO 2020). For more comprehensive information on taxable income please visit the ATO website or speak to qualified a tax accountant.
Capital accumulation is slowed through taxation
When it comes to achieving financial freedom the accumulation phase is about building an investment portfolio as quickly and efficiently as possible within your risk tolerance. Typically, you’ll be working full time on your career and diverting as much excess income as possible to your investment portfolio. Anything that blunts a portfolio’s return has serious implications on portfolio growth in the long run and taxation is one of these factors. The two main ways that taxation does this is through capital gains tax and income tax on portfolio distributions.
Capital gains
Capital gains tax is triggered when an asset is sold for a profit. So, if you bought an asset for $5.00 and sold it for $8.00 within 1 year, you made a profit of $3.00. This $3.00 is declared as assessable income which, barring any deductions, will be taxed at your marginal rate. If your marginal tax rate is 39% (37% marginal rate + 2% Medicare levy) then you owe $3.00 x 0.39 = $1.17 tax.
Portfolio distributions
Portfolio distributions such as dividends, rent and interest are considered assessable income which means that they are also subject to tax at your marginal tax rate. For the purposes of this article I won’t be discussing franking credits as how they can be used as a source of retirement income warrants their own discussion piece.
Minimizing taxation
In general, minimizing taxation is about reducing the amount of taxable income that an individual has. As per the equation above, this can be done either by reducing the amount of assessable income or by increasing the value of allowable deductions. For the purposes of this article I’m going to focus primarily on the levers that we use at the FFE house to reduce the amount of assessable income during the accumulation phase of our FI journey.
Buy and hold strategy
Buying and holding assets for the long term is a tax effective strategy because capital gains tax is halved if an asset is held longer than 1 year. As you know, we do not employ a strategy that involves buying and selling assets frequently; this is also extended to our choice of low turn-over funds. When our asset allocation strays too far from our targets, we rebalance our portfolio by diverting a larger proportion of new money into the underweight funds as opposed to selling out of our overweight positions – the one disadvantage of this is that it results in a longer time taken to reach our target asset allocation.
Cash reserves and planning purchases
We maintain a suitably sized cash reserve and plan for future large expenses which means that it is highly unlikely that we need to liquidate our portfolio to fund large expenses. This along with our buy and hold strategy for accumulating assets helps to significantly reduce our capital gains tax declarations.
Choosing funds with low distributions
Because we both currently earn an income, we do not need portfolio distributions to facilitate our lifestyle spending; this means that it is more tax effective to grow our portfolio through capital price appreciation. This is one of the reasons why we choose to own less REIT’s and more international funds – low distributions mean less tax.
Debt-recycling
I am not a fan of non-deductible debt such as your standard mortgage, car loans and credit card debt. As the name suggest non-deductible debt cannot be used to reduce taxable income which is why it’s important to reduce this quickly. If a household’s main source of non-deductible debt is a mortgage, one option is to transform the non-deductible debt into deductible debt using a debt recycling strategy which I have previously discussed in this article.
Something that I can’t stress enough is that debt increases risk; both on the upside and downside. For us, the interest payments and account fees form part of our allowable deductions, which allows us offset some of the fund distributions that we receive.
Reducing taxation is not the top priority
In terms of accumulating a suitably sized investment portfolio wealth creation should always be a higher priority than tax reduction. Taxation is an issue that creates a drag on returns however investment decisions should be primarily based on the risks and opportunities they present to the investor. For example if you purchased a stock at 10c and within a few months it rose to 30c and you believe it won’t hold this value long term then selling the stock for a 300% profit must be your top priority; do not let capital gains tax be the primary driver for action/inaction. Similarly, you should not take on a loan purely so that the interest can offset your portfolio distributions; the reasoning should be more around wanting to increase risk to match your investor profile with deductions being a side benefit.
Concluding thoughts
The Australian tax system for individuals is a progressive income tax system. While this post has provided some considerations for reducing tax while accumulating wealth, because the system is so complex, I haven’t even scratched the surface of what can be done. In short, the strategies to reduce tax that I’ve highlighted today are focused around reducing assessable income and capital gains. Some of these ideas include:
- Buying and holding assets for at least 1 year
- Debt recycling
- Proper cash management
- Choosing funds that with lower distribution rates
With that being said taxation needs to be considered when making investment decisions however it should be never be the primary consideration when making investment decisions.
Engineer your freedom
References
Australian Taxation Office, 2020, Individual income tax rates, Australian Taxation Office, viewed 16/9/2020, <https://www.ato.gov.au/rates/individual-income-tax-rates/?=top_10_rates>
Australian Taxation Office, 2020, What is income?, Australian Taxation Office, viewed 20/9/2020, <https://www.ato.gov.au/Individuals/Income-and-deductions/In-detail/Income/What-is-income-/>
Australian Taxation Office, 2020, Medicare levy, Australian Taxation Office, viewed 20/9/2020, <https://www.ato.gov.au/Individuals/Medicare-levy/>
Australian Taxation Office, 2020, Deductions you can claim, Australian Taxation Office, viewed 20/9/2020, <https://www.ato.gov.au/Individuals/Income-and-deductions/Deductions-you-can-claim/>