What are you going to do with those tax cuts?

How the new tax cuts are spent, or invested, is absolutely an individual choice – and probably a joint decision for most couples.

Over the coming weeks, around 12 million working Australians will start receiving extra cash in their pay packets.

It’s a pay rise that’s largely come about from changes to personal income tax brackets that were announced by the federal government in the 6 October budget.

By lifting tax bracket thresholds, more Australians will now be paying less overall tax. Most individuals will receive a tax cut of between $1060 and $2745 per year, depending on their taxable income.

The individual tax savings equate to between about $20 and almost $53 per week more in after-tax cash income.

What’s more, since the start of the new tax scale has been backdated to 1 July this year, workers also will receive a one-off lump sum amount for the higher income tax rates paid since the beginning of this financial year after they lodge their 2020-21 annual tax return.

Working couples, of course, will receive a double benefit in terms of more combined weekly income and two backdated lump sum payments.

What are you going to do with the money?

Scientist Albert Einstein famously described compound interest as “the eighth wonder of the world”.

Einstein rightly calculated that any savings balance will grow significantly over time when interest payments are added.

As an initial balance increases, so does the size of the interest payments made because they are applied to the higher savings balance amount.

As such, even a small weekly deposit amount will steadily add up over time when combined with compounding investment returns on the growing savings balance.

Under the next tax rates a person on a taxable income of $40,000 per year will now be receiving an extra $1060 a year in take-home pay as a result of the government’s announced tax changes. This works out to $20.40 per week. Someone on a taxable income of $120,000 will receive an extra $52.79 per week.

A close look at the announced tax savings shows how regular deposits can add up over time with the benefit of compounding returns.

Take, for example, a hypothetical starting balance of $5000 and calculate returns using an annual return of 8 per cent.

The outcome largely matches the 7.9 per cent actual annualised total return from the top 300 companies listed on the Australian share market over the past 10 years.

To simulate the effect of compound interest, the total return assumes than an investor had reinvested all of the company dividends that were paid since 2010 back into the Australian share market.

This would have been possible using a broad Australian share market fund offering a dividend reinvestment program (DRP) option. In this way, whenever dividend distributions are paid, they are converted into additional fund units. 

The annualised 8 per cent return number used in these calculations is for illustration purposes only. Past investment performance should never be seen as an indicator of future performance.

However, the long-term positive effect of compound growth would still apply on lower annualised returns. Investing the new tax savings directly is one just one option, individuals also may want to consider channelling their higher after-tax income into their superannuation account.

It’s now possible to make after-tax payments into a superannuation fund, up to the annual allowable $25,000 concessional limit, and then claim a 15 per cent tax refund deduction in the next year’s tax return.

That’s because superannuation payments are generally paid from one’s salary using pre-tax income, and are concessionally taxed at 15 per cent.

In a practical sense, what that means is that individuals can use the new tax cuts to claim an additional 15 per cent deduction by directing their after-tax income into superannuation.

Done over an extended period of time, such a strategy will have the same benefits of compounding returns as someone investing outside of superannuation, but have the extra benefit of being able to claim a tax deduction – which also could be reinvested.

How the new tax cuts are spent, or invested, is absolutely an individual choice – and probably a joint decision for most couples.

Used as part of a disciplined, low-cost and diversified long-term investment strategy, however, the benefits of making regular deposits and leveraging compounding returns are clear.

Tony Kaye is senior personal finance writer at vanguardinvestments.com.au