How to cut your tax bill – the best government approved tax shelters

The controversial tax change on super accounts holding more than $3 million has shone a light on the tax effectiveness of various investment strategies.

This can be a good thing given that with rising prices everywhere, there has never been a better time to check out how to build assets for the future and ensure a good standard of living.

So, what are some of the best ways to safely and legally reduce your tax bill and invest for the future?

In a handy co-incidence, the Australian Federal Government has just released a list of the main sources of revenue leakage, which is not too hard to reverse engineer to see where some of the better ways to save on your tax bill are.

So here is our list of legal tax shelters, although it is very important to first consider that tax and tax savings should never be the driving force behind your investment decisions.

A pig wearing lipstick is still a pig and Australian investment history is littered with the corpses of failed tax-driven investment schemes that achieved the biggest deduction of them all – the removal of all of your invested capital.

From ill-fated movies, to avocado farms and “managed” forests, it has always been very possible to claim a big, upfront tax deduction but doing so without really checking out the underlying investment and its potential is a recipe for disaster.

So here they are, the list of government approved tax shelters that can be used to safely grow wealth, so long as the underlying investment is a good one and not hand-picked for its tax effectiveness.

Super still wins

It may be a surprise to still see super here, right at the top of the list.

Hasn’t the tax change ruined everything and left us all to consider other alternatives?

In a word, no!

For the absolute vast majority of taxpayers, the changes will have no impact on the attractiveness of super as the number one tax shelter available to everybody who is employed.

If you happen to eventually get hit with the 30% earnings tax on super you should consider it a badge of honour because it means you have successfully put together an amazing portfolio of assets that will enable you to live a lavish lifestyle.

You will be so wealthy that you can afford the best accountants and lawyers to structure your affairs to reduce tax, but this situation will only apply to a tiny sliver of the population who are already very wealthy anyway.

Initially, only 80,000 people with more than $3 million in their super will be affected and that number is estimated by Treasury to grow to about 500,000 people in 50 years.

Anything can happen in the next 50 years and rather than worry about a potential tax increase way into the future, let’s focus on the tax benefits of super right now.

For a start, most of your contributions into super are taxed at just 15% on the way in – less than the personal tax rate for all bar those on low incomes.

Then the earnings in the fund are taxed at just 15% – in reality, probably less given the benefits of franked dividends.

Indeed, even the much hyped 30% investment tax for those with more than $3 million will fall to around 22% in many funds once franking credits and concessional capital gains are taken into account.

The other taxes on super are also small – 15% on earnings within the fund and zero – yes you read that right – when paid out to someone who has met the retirement criteria and is aged over 60.

The disadvantage of super is also its biggest strength – in general it can’t be withdrawn until retirement – so it is inflexible but also unbreakable and rightly without peer in its tax concessions.

If I could have a word of advice to my very much younger self now, it would be to contribute as much as I possibly could to super until the age of 30, allowing the wonders of compound interest and a concessional tax rate to weave their magic long after I had returned to just paying the required minimum.

However, the young are foolish and alas, I was no exception.

Buy a house or apartment to live in

I realise this will be tough reading for the almost three-quarters of young Australians who believe they will never be able to buy a home but it remains a terrific, if difficult to afford, tax shelter.

While a recent survey found that a staggering 72% of respondents aged between 18 and 34 don’t think they will ever be able to buy a house, but that may partly be because of the significant tax advantages of owning your principal place of residence that has fed into higher prices.

Not only does a home provide shelter, it is also a totally tax-free asset that is treated concessionally when qualifying for the pension.

In other words, if you buy a house and live in it for a while, you can sell it down the track and the entire amount is yours to keep.

That is a hard feat to replicate anywhere else and is part of why Australia remains fairly property obsessed.

However, with prices now down significantly in Melbourne and Sydney, it is fairly discouraging to hear such widespread disillusionment from the young about the chances of them getting a first foot on the property ladder.

According to the Treasury paper, the capital gains tax exemption for the family home costs $48 billion a year in capital gains tax exemptions.

That puts it right up there with the cost of the super tax concessions.

However, even if buying a modest place to live is no longer on the radar of many young people, there are other ways that they can grow their wealth in a tax advantaged way.

Negative gearing

Super contributions are one thing, but how can you save tax and build assets that can be used before reaching retirement age?

The answer, with a very important qualification, is negative gearing or, more correctly, borrowing to invest whether the gearing is positive or negative.

To get that very necessary qualification out of the way first, borrowing to invest always increases risk and that risk can be financially catastrophic if it becomes too big, so this is not a strategy for the foolhardy or the over-confident.

However, borrowing to invest is a fantastic strategy if it is done carefully because it magnifies the size of your invested capital and the returns, allowing you to build up an asset that is hopefully rising in value and if sold will involve capital gains which are more concessionally taxed than personal exertion income.

Most people think that negative gearing only applies to property and while that is the most popular use, I personally think that borrowing to buy shares is a better strategy.

Negative gearing works on virtually all assets with the basic idea being that if the amount of interest you pay for the loan together with deductions for expenses exceeds the income produced by the asset, the amount you are out of pocket can be claimed in your tax return against your personal exertion income.

The important thing to note here is that this strategy always leaves you out of pocket – you might be getting a tax deduction but the overall strategy is to make a capital profit down the road at the expense of current income.

This is another risk of the negative gearing strategy – if you borrow too much and the current “negative” payments become too large due to rising interest rates or other factors, you may become a forced seller or go through some significant financial pain.

Every asset you borrow against for a negative gearing strategy has its own pluses and minuses.

Property is the main asset used because banks will lend more against property than any other asset – potentially all the way to 90% or more but more usually for those who want to avoid paying mortgage insurance to 80%.

That lending is fairly secure too – it is highly unlikely that the bank will ask you to sell if the value of the property falls beneath the total of the loan – a situation that is unique to property.

The problem with property is that it often has quite low yields after expenses, usually well below the repayments on borrowings, and it is a really large and lumpy purchase.

If times get tough, you can’t sell off one bedroom to free up some capital, which is why property is usually seen as a long-term investment that should be held for seven years or more.

Shares have the advantage that they can be sold quickly and deliver your money within three days.

They can also be sold in parts, so that when circumstances change you can sell part but not all of your asset if required.

The other obvious thing about shares is that they can be volatile, with even the diversified whole of market ETFs or listed investment companies still falling or rising in concert with the overall level of optimism or pessimism of the investment community at the time.

Also, shares are usually geared using margin loans from brokers, which as the name implies rely on the borrower retaining a margin above the borrowed amount so that at any time the borrower can have their loan repaid by selling the shares.

I can say from experience that getting a substantial margin call at a time when the overall share market is falling quickly and unexpectedly is not one of life’s great experiences.

You are faced with the option of selling shares at a deep discount to maintain the margin or by topping up the account quickly with fresh cash.

That is why I think it is best to use less substantial borrowings on shares so you can more easily ride through the inevitable ups and downs.

Different brokers have different maximum lending percentages they will go to on individual shares with 70-75% the usual maximum but keeping a gearing level of around 40% gives a much greater margin of safety.

Of course, other loans such as lines of credit on property loans or other borrowings can potentially also be used to buy shares, with the usual caveat that all loans must be repaid over time, so it pays to be quite cautious.

Borrowing against shares comes with some extra tax advantages – many dividends come with franking credits which help to cut your tax bill and the interest cost of the loan for the following financial year can be paid in a lump sum in June and claimed back in the next tax return – a strategy that can also be used for property, although that will usually involve much larger numbers.

The other thing to remember is that there are now some ETF style products that allow the investor to get the magnification effect of gearing without going to the trouble of getting a margin loan.

You should note though that the internal gearing doesn’t allow for the same sort of negative gearing tax deductions as a margin loan, although the fund can probably borrow more cheaply than you can which may offset this disadvantage.

Betashares’ Geared Australian Equity Fund (ASX: GEAR) is effectively a hedge fund that offers internal gearing across the ASX 200, with the level of gearing usually around the 50% to 65% range.

There is little doubt about how popular negative gearing is in Australia with the Treasury paper showing that an estimated 2.4 million people claimed $51.3 billion of rental deductions in 2019–2020, resulting in a total tax reduction of $18.6 billion.

Of the total number of people with rental deductions, 1.3 million had a rental loss through negative gearing, which added up to total rental loss of $10.2 billion.

Those rental losses provided a tax benefit of around $3.6 billion in 2019–2020.

Invest in capital instead of earning income

What all of these tax advantaged investments have in common is that they involve earning income or returns from capital rather than income.

Personal exertion income in Australia is quite heavily taxed but capital gains are taxed much more concessionally.

There are many concessions on capital gains that can cut your personal tax rate on those gains in half or more but the biggest advantage of capital gains is that they are only taxed when the asset is sold, which is entirely in your control.

That means you can pick a low income year to earn some capital gains and pay very little tax on them.

However, the really big gains can be made when you never sell at all, with earnings from a well-constructed share or property portfolio being enough to support your lifestyle without the need to sell anything.

That is effectively the aim of superannuation and many other investments, some of which will even throw off tax advantages such as franked dividends on their returns.

Indeed, the basis of all of the main government tax shelters is that they rely on encouraging people to take risks with their capital to earn a return.

Which is a salient reminder to all investors that their main job is to ensure that they are confident that they are being appropriately rewarded for the risks they are taking with their capital.

Tax is just one element in the equation but the absolute key is to ensure your investments are good.

Please note: the above article is not financial advice, see a financial professional for more information on your specific circumstances.