The Good, the Bad and the Ugly of Tax Deductions

 

We find that tax deductions are often the least understood area of finance. People often spend money simply because it’s a tax write-off. But what they don’t consider is whether that expense will help them in some way in the future.
 
We’re not saying don’t make tax deductions – we’re saying make sure it is a good financial decision before going ahead, and know what you’re trying to achieve.
 
Below, we look at the good, the bad and the ugly of tax deductions.
 
The good:

1. Concessional contributions – individuals can put up to $25,000 into their super each year (this includes employer contributions) and claim the amount as a tax deduction. For 99% of people, this is an excellent way to save on income tax, because money going into super is taxed at 15% – a huge difference to the usual 34.5% to 39% income tax (that people pay on average). We frequently recommend our clients make the most of this allowance.
2. Carry forward concessional contributions. The $25,000 limit mentioned above carries forward to the subsequent financial year, and can be ‘back-dated’ for up to 5 years meaning it’s $75,000 in total. However, there is an ‘anchor point’ to the 2018/2019 financial year, which means at the moment you can only go back until then. Recently, a client of ours, Christine, sold a property and made some significant capital gain – $133,906 to be exact. Christine is a low-income earner, and between the 2018/19 financial year and now, her personal contributions to her super added up to $6,203. Overall, from the $75,000 cap space for those 3 financial years, Christine had $68,797 that she could put into her super – which is exactly what we advised her to do. What that meant was that the $68,797 was taxed at 15% rather than at the normal rate of income tax. Now this doesn’t work for everyone – for example Christine’s husband is a high-income earner so this wouldn’t have been possible to do on his side. For this financial year, with Christine’s salary at $25,000 plus the capital gain on the property, her income was $158,906. With the $68,797 of personal contribution taken out, only $90,109 was taxed at the normal income rate.
3. Get a 15% rate of return. As we said above, money going into super is only taxed at 15%. Make the most of that $25,000 cap each year so that your income is only taxed at 15% rather than double that amount in income tax. This is significant because the more your earnings go up, the more that money accumulates and the more there is at stake.
4. Franking credit. Publicly-listed Australian companies pay approximately 30% tax – and they pay that tax before they pay their stakeholders. As an investor, you get credit for the 30% tax that’s been paid. For example, if you receive a $10,000 dividend, you lose 15% in tax, but get a 30% credit. For $1 you lose 15c but get a 30c tax credit. This is only for Australian companies, of course – and while investing in Australian shares is more tax effective, it’s still important to have a diversified portfolio.
5. Moving your tax into a super income stream. Once you are 60 and / or retired, you can move your super into a 0% tax environment. The cap for the amount you can have is $1.6 million per person – so you can have up to $3.2 million per couple. We say this is like investing in a tax-free company. We’re lucky in Australia that we get a tax deduction when we put money into super, and get the money tax-free on the way out. No other country in the world has it this good when it comes to super.

The key to a good tax deduction: ask yourself if the money spent will be a good investment in the future. Are you able to turn $1 into $2 and do it in a tax-effective way? If yes, then go for it.
 
The bad:

1. Negatively geared rental property. You might pick up tax savings doing this, but it’s not the most effective use of cash. The tax deduction simply makes it more attractive. Over 10 years, it may not work out to be very cash-effective. We’re not saying this doesn’t work in every single case, especially for young people, but we are talking averages here, and considering the fact that our clients are over 50. Here’s an example. A rental property has $30,000 in rental return, but also has expenses (rates, insurance, maintenance, depreciation) and loan repayments of $50,000 a year. The property is then negatively geared at $20,000. What people then get back is 39% of that $20,000 ($7,800) meaning they’re $12,200 out of pocket. Over 10 years, this is $122,000. That amount is huge – capital growth most likely would not cover this amount. So as you can see, negatively gearing property may not pay off in the future like personal contributions to super would.

 
And finally, the ugly:

1. Salary packaging cars! If you’re a business owner and you have a tax deductible car or ute then often it’s a different story. But if you’re not, we don’t see it working so well. The fact is, you are buying a depreciating asset – that car is never going to be worth more in the future. While people see the car as being free, or being a huge saving, what ends up happening is that they tend to buy a car that’s twice as expensive as what they want or actually need. And then there’s the balloon payment at the end which can be around 30% if they want to buy the car. The way this salary packaging works is that you are provided with daily or weekly figures which makes it seem like you’re spending less. It isn’t hard to see how people are convinced. On the flipside, people who buy cars outright never end up doubling their budget. You don’t go out wanting to spend $20,000 on a car and accidentally spend $40,000 – but we often see this in salary packaging. One of our clients recently wanted to end the salary packaging for his car but was stuck in the contract for 2 years. There are fortnightly deductions from his pre-tax dollars which add up to $11,000 a year. Without the car, he would normally receive $6,710 of that in his pay (after paying 39% income tax). So he has a total tax saving of $4,290. It is $15,000 from his post-tax wage for the lease plan per annum. His total wages for the year are reduced by $21,710. Another thing that people are drawn to is that these packages include everything – fuel, insurance, rego, tyres, servicing and so on. But if you own a car outright, it only costs around $10,000 a year if you allow $1,000 for rego, $1,000 for insurances and $2,000 for tyres, servicing and repairs. Fuel would be approximately $6,000. Much, much cheaper than leasing. Of course, we also need to consider opportunity cost – which is what your money is missing out on when making such repayments. Our client’s $11,000 could be going into his super each year and growing exponentially. In our opinion, there is no better way to own a car than to have it fully paid off. For more info on this, check out our podcast: Drive a $15,000 car to draw an extra $717,000 in retirement.

 
Remember, we’re not saying don’t make tax deductions. We’re simply saying that just because something is tax deductible doesn’t make it a good business decision.

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