Investment tax planning biggest mistake Aussies make on returns

The average Aussie pays $21,246 in tax but this common error means many are paying thousands more than they need to.

In Australia we pay a lot of tax. ABS data shows the average income earner pays $21,246 of income tax alone.

But while tax is important, you don’t want your annual donation to the ATO to be any bigger than it needs to be.

Because the tax rules are complex, it’s easy to make mistakes. One of the biggest tax mistakes I see is one that’s hidden below the surface. It often goes unnoticed for years, but when discovered it can cost you tens or hundreds of thousands, if not millions.

RELATED: How to get your $1080 in tax back

Are you leveraging the most out of your tax return?

This mistake is not tax planning before you invest.

It happens because when most people invest they’re focused on choosing a good investment, and don’t realise that’s only half the battle …

While your headline investment return is important, it’s not the most important thing. You should instead be focused on the true ‘profit’ or return you’ll get on your investment after the tax is paid. There’s always a substantial difference between the two.

Here I’ll cover the key areas you should be thinking about so you maximise your bottom line when you invest.

Leverage the difference between high and low tax rates

One of the things that can help boost your after tax investment return is leveraging the difference between higher vs lower tax rates between taxpayers.

This can work for couples investing together, or anyone using other ‘tax entities’ like a trust or investment company.

One opportunity to leverage the difference in tax rates is where one person in a couple has a higher tax rate than the other.

This happens commonly when a couple starts a family, taking time out of the workforce, but can also happen if one part of a couple is looking to start a business, change career direction, or for extended travel.

An example of leveraging lower tax rates

Take a couple that both earn the Australian average income of $89,128 that have just had their first child, with the mum taking nine months out of the workforce. This would make the mum’s annual income total $35,852 – made up as $22,282 for the three months worked in the year + $13,570 government paid parental leave.

For someone earning up to $45,000, the marginal tax rate is 19 per cent, meaning you pay 19 cents of extra tax for every extra dollar of income you earn.

Let’s assume the mum and dad have a share portfolio that pays them a dividend return of $5000 annually. If these shares are held in her name, the dividend income of $5000 would need to be included in her tax return. Then tax would need to be paid on the dividend of $950 based on a 19 per cent marginal tax rate.

If the shares were held in his name instead, based on his income and marginal tax rate of 32.5 per cent, he would need to pay tax of $1625.

RELATED: Crazy things Aussies tried to claim on tax

Knowing who best to attribute share portfolios to is one way to save on tax.

Dad’s tax on investment of $1625, means an after tax return of $3375. Mum’s $950 tax bill implies an after tax return on investment of $4050.

The difference between the two is $675, which when you put it into percentage terms, the mum’s investment return is a whopping 20 per cent higher than the dad’s. And, as your income and investments grow over time tax savings are amplified further.

When you invest through property, over time you’re looking at growth in the hundreds of thousands of dollars (or more). That implies finding a way to strategically sell the property (and realise the taxable gain) in a year where one person in a couple has a lower taxable income and lower tax rate can save big tax dollars.

A word of warning here – solid planning before investing is essential to take full advantage, because the difference between marginal tax rates for different people and entities often changes over time.

You can also leverage higher tax rates

When an investment property is negatively geared, you’re able to claim a tax deduction for the mortgage interest and other property costs. The higher your tax rate, the more of a tax deduction you receive and the more tax you save.

This creates an opportunity where a person with a higher tax rate receives more of a benefit from the tax deductions from a negatively geared property.

RELATED: 6 steps to buying a house

Leveraging higher tax rates from an investment property means you can save at tax time. Picture: Joel Carrett/NCA NewsWire

But on the flip side, you need to be aware that if the property is sold while you still have a high tax rate you can be up for more tax on the capital gain on the property.

This shows there’s no one-size-fits-all strategy, but you can also see that using the rules to your advantage will make a big difference to the amount of ‘profit’ you get from your investment after tax.

But, there’s another dimension to consider if you want to structure your investments in the best possible way for you.

Trusts and investment companies

Another method that gives you even more control of the tax outcomes on your investments is through the use of tax entities like trusts and investment companies.

Trusts allow the freedom to distribute your taxable income and capital gains across multiple taxpayers. This can save you a heap of tax through the ability to change who you send taxable investment income to every year.

Then, each year you can choose who to distribute taxable income and gains to based on what gives you the best after tax investment outcome.

Again, be aware there are some trade-offs and downsides to setting up trusts and other tax entities. Set-up costs, ongoing costs for your tax returns, and buying property can involve more complicated trade offs like different land tax and mortgage interest rates.

Change is hard

Be aware that moving investments from one taxpayer to another (including a trust or company) isn’t a simple thing because it’s considered a transfer of ownership. Ownership transfer is essentially treated as if your investment was sold.

This means tax will be payable on any gain, and if you’re transferring ownership of a property you’ll need to pay stamp duty again – a total disaster.

There can also be other costs involved, like tax preparation costs and legal fees that further take away from the after tax return on your investment.

Transferring ownership to save on tax can be costly in itself. Picture: Gaye Gerard/NCA NewsWire

This means it’s important to get your tax structuring choices right from the start, given it’s complicated (and expensive) to change things after you get started investing.

Ultimately, you need to make sure the tax benefit you receive from using a trust outweighs the costs of any of these trade-offs.

But, given the amount of tax you can save, the potential is there for benefits in the tens of thousands yearly well exceeding set-up and ongoing costs.

Using the right entities (at the right time) is a serious choice and not something you should make without knowing the rules. It can be hard to figure this all out on your own, so if you’re thinking about using trusts etc don’t be afraid to engage a good professional to help.

To make sure you get the right advice, look for someone with a proven track record, that works with people like you, and who does this sort of work regularly so you can feel confident they will be able to deliver for you.

The wrap

There is no one right or wrong answer or approach when it comes to your investment tax planning, there’s only what’s right for you. But you should know that it is important, and will be a big driver of your investment results.

The key to setting things up in the right way for you is mapping out your investment strategy today and how your money and lifestyle will evolve over time. This allows you to optimise your tax structuring today and into the future.

You’ll be set to choose great investments and structure them in the right way to give you a great after tax return.

Ben Nash is a finance expert commentator, podcaster, financial adviser and founder of Pivot Wealth, Author of the Amazon Best Selling Book ‘Get Unstuck: Your guide to creating a life not limited by money’.

Disclaimer: The information contained in this article is general in nature and does not take into account your personal objectives, financial situation or needs. Therefore, you should consider whether the information is appropriate to your circumstances before acting on it, and where appropriate, seek professional advice from a finance professional.