Common tax planning strategies explained

There are many different types of tax planning strategies:  Strategies for obtaining tax deductions  Strategies for obtaining tax offsets credits  Strategies for moving income away fr

Common Tax Planning Strategies

Explained:

A holistic approach to tax efficient wealth building

Travis Morien Compass Financial Planners Pty Ltd

08 9332 0544http://www.travismorien.com

Basic principles

 There are many perfectly legal and socially

acceptable ways to increase your wealth in a tax efficient manner Some of these methods are

very powerful Legitimate methods of increasing your tax efficiency are called “tax planning”

 Methods that are unlawful are categorised under two different labels:

 “Tax avoidance” is where you set up contrived

accounting structures and strategies that abuse a

loophole so you can claim large tax deductions or take advantage of some benefit that was never intended to

be used in such a way.

 “Tax evasion” is where you deliberately try to hide

income from the Tax Office, by various methods

including secret bank accounts, not recording cash

transactions, “cooking the books” etc.

The focus of tax planning

 Tax planning should only ever be done with a view to

increasing your total wealth.

 There are some people that enter into all sorts of

dubious arrangements in order to obtain a tax

deduction, including trying to minimise their income.

 Minimising your income is silly, what you want to do is increase your assets and/or after tax income

 Some popular tax planning strategies are highly effective

at reducing your tax, but produce little benefit in terms

of wealth creation Some strategies actually make you worse off, either immediately or in the long term.

 Hence, tax planning is just a subset of overall financial planning, which needs to take into account investment strategy, retirement planning, wealth building etc.

Legality and ethics

 There is always a grey area between tax planning, tax

avoidance and tax evasion, and the Australian Tax Office has

a surprising amount of discretion to decide where the

boundaries lie.

 It should be remembered that just because some “expert” says it is ok, doesn’t mean that it is ok Also remember that just because a tax adviser openly advertises the strategy in a newspaper doesn’t mean the Australian Tax Office has

approved the scheme There have been many high profile prosecutions over the years and the fact that “everyone does it” makes the ATO more likely to shut it down.

 In other words, be careful about listening to advisers that

seem to recommend “too good to be true” strategies like

clever loopholes and novel types of trust that are supposedly

a closely guarded secret of “the rich”.

 Serious penalties including huge fines and jail terms may

apply if you do something illegal Blaming your advisor

usually won’t get you off the hook.

“The Secrets of the Super Rich”

 Contrary to what many “poor” and “middle class” people have been led to believe, there really are no secret techniques used

by the wealthy that enable them to get through life paying little

or no tax.

 Wealthy people often employ very good advisors but strategies used by the wealthy are almost always the same simple

strategies mentioned in this presentation The difference is

that a skilled advisor knows how to best combine these

strategies for overall results.

 People generally get wealthy not by using some flashy “secret” technique, but because they were good at building a business

or investing wisely

 Gurus promoting the idea of “secrets” are usually conmen

seeking to dupe the poor and middle class, you generally don’t find millionaires lining up to attend $10,000 seminars

advertised in the newspaper Most wealthy people that I know scoff at such seminars.

There are many different types of

tax planning strategies:

 Strategies for obtaining tax deductions

 Strategies for obtaining tax offsets (credits)

 Strategies for moving income away from an

entity paying a high rate of tax to an entity

paying a lower rate of tax

 Strategies for moving profits and losses between tax years, either to defer tax or take advantage

of a more favourable tax rate

 Strategies for reducing the amount of assessable capital gains from an investment sold at a profit

Deductions vs offsets

 When you claim a tax deduction for something, you obtain a tax benefit equal to the amount of tax you would have paid on that income at your tax rate For example, if you are on the top

marginal tax rate of 48.5%, claiming a $100 Tax deduction will produce a tax benefit of $48.50

 An offset is a credit against tax payable If you are entitled to a $100 tax offset, your total tax bill will be reduced by the full $100

Moving income between entities on

different tax rates

 The term “entity” has a very broad meaning and can include different people, companies and

superannuation funds

 A common and very simple example of this is

when a couple make income producing

investments in the name of the partner on the

lower tax rate, often a non-employed spouse

 More complex strategies may involve structures like a discretionary trust, the trustee may be

able to choose the best way to distribute income between several beneficiaries which may include people or companies

Moving income between tax years

years If you are working now but likely not to be working in a few years (retired, holiday, ill etc), then you may be on a lower tax rate then It might be sensible to defer the sale of any assets trading at a capital gain until the lower income year.

income if they expect a substantial increase in

taxable income in the future.

into a tax year that may be many years from now is

to invest in an agribusiness scheme.

More tax efficient investing

 One of the biggest expenses to a successful

investor is capital gains tax (CGT)

 Every time you sell an eligible asset at a profit, you need to remit part of that gain to the

Australian Tax Office as CGT

 A discount of 50% applies if you hold the asset for more than one year, so medium to long term investments are vastly more tax efficient than

shorter term trades

 Many people overlook the fact that if you defer the realisation of a capital gain you get to keep your unrealised tax debt in the market earning you dividends There is actually a small but

significant increase in your effective rate of

return if you can keep portfolio turnover down

Managed funds and tax efficiency

 It pays to check on the tax efficiency of any

managed fund you are thinking of investing in

 Some funds have a relatively low portfolio

turnover and tend to actively manage their

taxable distributions to reduce the tax burden to their investors

 Other funds trade excessively, and make huge distributions every year, much of it non-

discountable short term capital gains

 Obtaining such information isn’t easy if you are a general member of the public, this is where a

good financial advisor can be of assistance

Tax offsets

 There are so many different tax offsets that you should talk to an accountant to see which ones you can claim

 Common ones include franking credits on share dividends, low income tax offset, Senior

Australian’s Tax Offset, spouse superannuation contributions offset, personal super contributions offset, dependent spouse offset, family tax

benefits part A and B, baby bonus and many

more

The three tax systems of Australia

marginal tax rate system The higher your

income, the higher the average rate of tax you pay Capital gains on assets held more than one year are taxed at half of your marginal tax rate

income of 30% No discounts apply to capital

gains

and 10% on long term capital gains A

surcharge may also apply for contributions for

high income earners

but is outside the scope of this discussion as it has limited applicability to investment strategies

Personal tax rates for Australian residents

Personal tax system cont’d

 Contrary to what many people think, your marginal tax rate

is not equal to your average tax rate.

 For example, if your income is $80,000, you will be on the top marginal tax rate Including Medicare Levy, the

marginal tax rate of such a taxpayer is 48.5%.

 The amount of tax actually paid by someone earning

$80,000 is $24,512 including Medicare Levy This works out

to an effective tax rate of about 31% The top marginal tax rate only applies on the last $10,000 of income, though of course any additional income would be taxed at 48.5% and most tax planning that we do will be on dollars that would

be taxed at the highest rate.

 For long term capital gains (asset held more than one year), the capital gain profit is first discounted by 50% and then added to assessable income at marginal tax rates.

that capital gains will always be taxed at 30%, rather than

the effective top rate of 24.25% paid on long term gains

earned in the name of a person.

 Companies are distinct tax entities recognised by the Tax

Office, and can retain income and assets in their own name and need to lodge their own tax returns.

 A common tax planning strategy is to retain and reinvest

income in a company, only drawing a dividend when the

shareholder’s tax bracket equals 30% or less

 Companies can be used as an efficient “parking” vehicle to

defer personal income tax.

Trusts and other structures

 Unlike a person, company or a superannuation fund, trusts are not entities that pay tax A trust is a “fiduciarial

obligation” between a trustee and the beneficiaries.

 Investments can be made in the name of a trust, but all

income and capital gains must be distributed to beneficiaries every year or the trustee will pay tax at the top marginal tax rate on undistributed income.

 A “fixed” trust is set up so that all beneficiaries get a fixed entitlement to the income, capital gains and capital of the trust “Discretionary” trusts give the trustee a lot of

flexibility in determining how to make distributions and offer significant tax planning opportunities.

 Beneficiaries of trusts can be people, companies,

partnerships and other trusts.

 Although the superannuation system is

complicated and many people do not trust it,

super is still one of the most tax efficient ways to build wealth

 You only pay 15% tax on income in a super fund and the capital gains tax rate on assets held for more than a year is 10%

 Another advantage of super is that this is one of the most difficult assets for a creditor to get his hands on, so superannuation is ideally suited to business owners and professionals wanting a

protected place to store their long term savings

Reasonable benefits limits

 Superannuation is an excellent savings vehicle for long term

retirement savings The tax efficiency and the asset protection characteristics are so good that limits have been introduced

that stop very wealthy people from taking too much advantage

of it.

 A “reasonable benefits limit” (RBL) is the most one can take

out of super while still obtaining maximum tax concessions.

 The lump sum RBL is $619,223 in the 2004/05 tax year This figure is indexed each year with inflation.

 You can access a higher RBL, the “pension RBL” by putting at least half your benefit into certain “complying” income streams The pension RBL is $1,238,440 in 2004/05 The pension RBL

is higher to encourage people to convert their super into

pensions that will last at least for their life expectancy, rather than withdrawing it and spending it in a short period of time.

Withdrawing from super – lump sums

differently (we’ll gloss over the complexities in this

presentation), the most common components are “Pre 83”,

“Post 83” and “Undeducted”.

marginal tax rates 95% is tax free.

83” money from a superannuation fund before having to pay

any tax on this lump sum This figure is indexed upwards every year The balance of lump sum withdrawals is taxed at 15% (+ 1.5% Medicare), subject to reasonable benefits limits.

reasonable benefit limit are taxed at 47% plus Medicare, post 83 taxed amounts drawn as a lump sum in excess of your RBL are taxed at 38%.

Withdrawing from super – income streams

 Income streams are taxed at marginal tax rates, minus

a 15% superannuation pension tax offset The

earnings within the fund itself are tax free once the

fund begins paying an income stream

 Undeducted components create a “deductible” amount

of the income stream that is tax exempt The size of the deductible component varies depending on the

type of income stream, the term of the payments and your life expectancy

 Pre and Post 83 money withdrawn in the form of an

income stream that is in excess of the Reasonable

Benefits Limit is taxed at normal marginal tax rates,

but doesn’t attract the 15% pension tax offset

Superannuation contributions surcharge

 If your “adjusted taxable income” (ATI) exceeds

certain thresholds, an additional tax is paid on

contributions to superannuation This tax does not

affect earnings, just contributions

 Adjusted taxable income is your total remuneration, which includes salary, superannuation contributions

and fringe benefits

 If your ATI exceeds $99,710 (2004/05 tax year, figure

is indexed annually), you may be liable to pay some surcharge on your contributions This surcharge rate increases from 0 to 14.5% when your ATI reaches

$121,075 Below $94,691 surcharge is zero, above

$121,075 it is 14.5% If your ATI is inside this range,

a formula will apply

Superannuation contributions surcharge

 If your remuneration was $85,000 salary plus $25,000 super, you’d pay 6.02036% x $25,000 = $1,505.09 in surcharge, in addition to the $3,750 (15% x $25,000) you would have paid anyway in “contributions tax”

Strategies for obtaining tax

deductions:

 Salary packaging or direct deductions of

business expenses (if eligible)

 Claiming work, transport and some

self-education expenses as deductions

 Negative gearing (in fact, any gearing)

 Deductions associated with property

(depreciation allowances etc)

 Agribusiness

don’t have to pay income tax on that benefit.

 When you negotiate a remuneration scheme with an employer that includes salary sacrifice, this is called

a “salary package”

Salary packaging cont’d

 You can salary package virtually anything, but to stop abusive arrangements there is an extra tax paid by the employer called Fringe Benefits Tax (FBT)

 The amount of FBT paid on items that attract

the full rate of FBT is calculated such that the

employer pays the same amount of tax as if you had received it yourself and paid the top

marginal tax rate (48.5%) Naturally, the

employer will have to pass this cost on to you

and so you would gain no benefit on many

packaged items

Salary packaging cont’d

 Some benefits attract no FBT, some attract a

partial amount of FBT and some the full rate of FBT There is a tax saving if you take FBT

exempt items or items that attract FBT at a

 The most commonly packaged benefit that

attracts a concessional rate of FBT is a car

Depending on what you use the car for and how far you drive it every year, there can be a

substantial tax saving for salary packaging a car, usually with some sort of lease arrangement