Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.
Unconventional wisdom: Five ways to invest smarter under the new tax regime
“When the facts change, I change my mind – what do you do, sir?”
– John Maynard Keynes
The implications of the budget continue to dominate the news cycle. I want to provide some practical guidance for investors trying to navigate the new tax regime but first I want to acknowledge how many investors are feeling.
Building wealth isn’t inherently a selfish act no matter how it is portrayed. It isn’t about taking from someone else – it is about building a better future for yourself and those you love. Conversely, taxes are the price we pay for living in a civilised society.
Taxes and building wealth are not mutually exclusive. The level, use and fairness of taxes and the incentive structures in our tax system are all legitimate debates.
Regardless of your opinion about the budget, it has gotten harder for many investors to achieve their goals and that can be discouraging. Keep your head up. Investing remains one of the best ways to improve your future.
A new – and old – way to tax capital gains
A baseline scenario is useful to understand how the changes in capital gains taxes will work. For investors who remember the pre-1999 environment the indexation method of calculating capital gains will be familiar.
If an investor buys $1000 worth of shares on the 1st of July 2027 the cost basis of the shares will be adjusted upwards based on the level of inflation over the holding period. As the cost basis increases on a share that has appreciated, the capital gain – and tax – will reduce.
If the shares are sold for $2000 in five years on the 1st of July 2032 the difference in the cost basis and sale price will be subject to capital gains taxes. If inflation is 5% annually the cost basis will be adjusted from $1000 to $1276.
The gain subject to capital gains tax is now $724 and at a 37% marginal tax rate and 2% Medicare levy a total of $282 is owed to the ATO. Under the former 50% long-term capital gains discount $195 is owed in taxes.
In this baseline scenario an investor would pay 44% more in tax. In this scenario where shares double in five years inflation would have to be 8.44% annually for there to be no difference in tax between the old and new methodology.
Tax treatment of franked dividends and capital gains
Franked dividends are now treated even more favourably from a tax perspective than capital gains. Consider a scenario where the shares didn’t appreciate at all during the 5 years and $1000 of fully franked dividends were paid to an investor instead. The pre-tax returns in both scenarios are the same.
The franking credit in this scenario is $429. At a 37% marginal tax rate and 2% Medicare levy net tax payable is $128 compared to $282 for the same return coming from capital gains.
All returns are not equal. In this scenario the after-tax gain for a return entirely made up of capital gains is 71.80%. For a return entirely made up of dividends it is 87.20%.
A franking level of approximately 38% is needed for the same tax owed on dividends and capital gains in this scenario.
This is not a realistic scenario as returns generally come from both dividends and capital gains for most Australian shares. But the way dividends and capital gains are treated on a relative basis under the tax regime do have implications on the approach investors should take.
Does the new tax regime change the way you should invest?
The new tax regime does not change the foundational frameworks of investing. You still need the structure of a goal and investment strategy. You still need to get your asset allocation right and focus on minimising mistakes.
Another foundational investing concept is always remembering that the only thing that matters is the money that ends up in your bank account. After-tax, adjusted inflation returns should be the focus for all investors.
I’ve outlined five implications for investors to consider under the new tax regime.
Implication one: Super is even more attractive
The tax environment within super has not changed. The relative value of super’s tax concessions are based on the tax environment outside of super. Taxes have increased outside of super which makes super more attractive.
The following chart shows the baseline scenario I outlined above and includes the tax treatment of the same scenario in super. As you can see the benefit from investing in super in terms of after-tax returns increased from 12% to 20.70%.
Get as much money into super as possible as long as the restrictions inherent in super meet your financial goals. If your financial goals have a super and non-super component get as much money into super early and deal with the non-super component later in life. That gives the tax benefits of super a longer time to compound.
Implication two: The importance of asset placement
Asset placement refers to the optimal tax environment for each type of investment. There are several different structures investors can take advantage of including trusts, a corporate structure, super or a fully taxable account outside of super.
I am going to focus on super and fully taxable accounts as they are the most widely used investment structures.
After the budget there is a clear delineation between the way franked dividend income and capital gains are treated. This disparity in tax treatment has several implications.
As previously discussed, the best place to hold assets is in super. Investors holding assets inside and outside of super or those investing outside of super for a specific goal like early retirement should focus on asset placement.
Shares with a higher likelihood of returns mostly consisting of capital gains should be in the lower tax environment in super. Shares with a higher likelihood of returns mostly consisting of franked dividends should be outside of super.
The same principle applies to assets with higher expected levels of capital gains and lower expected levels of capital gains. Growth assets like shares should be in super and defensive assets like cash and fixed income should be outside of super.
This shouldn’t change your overall asset allocation but if your financial circumstances allow you to decide which assets are held in which tax environment choose the lower tax environment for assets with higher potential returns.
Implication three: Keep investing to build wealth
Inflation is one of the biggest impediments to building wealth. Not earning a return that exceeds inflation lowers purchasing power over time and turns the perceived safety of cash into an anchor holding you back from financial freedom.
Adjusting the cost basis of shares based on inflation further reinforces their attractiveness in a higher inflation environment. This doesn’t mean higher taxes don’t hurt but you still need to invest to grow your wealth to grow on an inflation-adjusted basis.
Implication four: The relative attractiveness of housing vs shares
In much of the world people invest in residential real estate for a combination of income generation and price appreciation. This isn’t the case in Australia.
Skyrocketing housing prices have led to negative initial yields on residential real estate in much of the country.
Negative gearing allowed real estate investors to offset the negative yield while taking advantage of capital appreciation. Going forward this wealth building formula no longer is feasible except on new property purchases where negative gearing is still applicable.
On a relative basis this makes investing in shares more attractive than investing in existing residential real estate.
If you already own an investment property with grandfathered negative gearing it makes that property more valuable to you than other investors.
However, if the projections of slower residential real estate price appreciation from the government come to fruition your future returns may be less than you’ve anticipated. Rents are also projected to rise so this may make your property cash flow positive faster.
Personally I am taking all of these projections with a grain of salt. The impact on existing residential property investments will be more apparent over the next several years.
Implication five: Hold shares for longer
I’m a proponent of longer holding periods as it provides the opportunity for a thesis to play out instead of the short-term noise that influences share prices.
The old tax regime encouraged a one year holding period to capture the capital gains discount. Things have shifted in the new environment for non-super assets.
Longer holding periods now provide discounts based on the constant erosion of purchasing power through inflation. The following two charts show the differences in capital gains taxes in two different inflation scenarios – 2.5% and 5% annual inflation.
You will notice two differences as the holding period extends. The first is the percent increase in capital gains taxes owed on an investment that doubles in value compared to the old tax regime. This is the discouraging aspect of the new tax regime. The good news is that the increase ir reduced as the holding period extends.
Impact from 2.5% annual inflation:
Impact from 5% annual inflation:
The 50% capital gains discount meant there was no additional tax benefit between holding a share for one year and one day and holding it for ten years. That is no longer the case as the discount gets larger due to cumulative inflation over a longer holding period.
Final thoughts
Regardless of how you feel about the investment-related provisions in the new budget it is a good time to revisit your goals. Setting goals introduces a dose of reality to your dreams of the future. Goal setting is not supposed to discourage you. It is meant to help you formulate a realistic plan to get what you want out of life.
For goals with a non-super component the pre-tax required returns have gotten higher in most plausible scenarios. If those returns are no longer achievable there are other levers to adjust – save more money, delay the date you want to achieve your goals, optimise your tax situation and / or adjust your goals.
This is not the first tax change investors have faced, and it won’t be the last. It takes time to absorb any change but the quicker you can get to the constructive part of the process the better. Take a step back and figure out the best pathway forward to creating the life you want.
Email me at [email protected] and let me know how you are approaching the new tax regime.
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What I’ve been eating
I spent the weekend in Canberra and returned to one of my favourite spots in the city – the Capital Brewing Taproom in Fyshwick. Brodburger’s signature red caravan sits in the taproom which makes the whole experience even better.
This is a solid burger. It may not be the Gidley burger but few are. This is the signature Brod with lettuce, tomato, spanish onion, aioli, tomato relish and cheddar. Wash it down with several XPAs and you’ll have a good afternoon.
