Minimising taxes as an investor
Choosing to invest as an individual or within a company or trust has several tax consequences for investors.
Tax is part and parcel of investing and an often-overlooked component of achieving your investment goals. It is a key determinant of your total return, as it can take away almost half of the return from an investment. Superannuation is one of the most tax effective ways of investing and saving for retirement. What about investors who have investments for goals outside of retirement? Outside of investing as an individual, there are two main vehicles that you can invest through with differing tax implications – trusts and companies. Deciding which vehicle to invest in can have major ongoing cost and tax implications. The major differences to consider before deciding to invest in a different vehicle are explored below.
Individuals
This structure is simply putting your investments under your own name and paying personal income tax and capital gains.
This structure is relatively straight forward and requires you to include your investment income and capital gains in your tax return annually. The amount that you pay will be determined by where you sit on the marginal tax rate ladder.
Investing as an individual gives you limited to no flexibility to redistribute income, which is one of the main benefits of a trust structure. You are able to seek a tax professional for income tax advice, but you are also able to be a self-advised individual which involves no cost or set up fees.
As an individual there are several ways that you can lower your tax burden. The first is to maximise superannuation contributions to take advantage of the lower tax rates during the accumulation phase and tax-free withdrawals during the pension phase. You can also ensure assets with higher expected returns and therefore higher potential tax payments are placed in super while assets like cash can be held outside of super. Finally, investor behaviour plays a role in tax outcomes and limiting trading will limit taxes.
Trusts
A trust is a person or organisation that holds assets for the benefit of beneficiaries.
Trust structures can help redistribute income, and therefore tax obligations, amongst multiple people. The most common use of trusts is for families, where income from investments can be distributed to lower income earners.
For example, there are four people in a trust. There are two high income earners on the highest marginal tax rate, and two individuals who are full time students with no income. The investment income would be better redistributed across all trust members.
Trusts must distribute income in the same year that the income was earned – it cannot be carried forward. Although it can distribute income, it cannot distribute any losses. The only way that these losses can be distributed is by offsetting them against gains. These losses can be offset in the same year or carried forward to offset against future income.
Trusts can still utilise the 50% capital gains tax discount after holding an asset for 12 months.
To set up a trust, you would in most instances seek the advice of a tax professional. Trusts have set up costs, administration costs and ongoing costs.
Companies
The major difference of setting up a company is that it is a distinct, separate entity. The profits and debts that are held by the company in the process of investing do not become the profits and debts of the individuals.
The tax rate is also 25% or 30% (dependent on circumstances), which is preferable to the higher marginal tax rates. The main circumstances that determine whether you are eligible for the 25% tax rate are:
- the company’s aggregated turnover for the income year is less than $50 million; and
- 80% or less of the company’s assessable income for the year is ‘passive income’.
We encourage long-term investing over trading. Long term investors will receive the 30% tax rate for companies.
Companies are not eligible for a CGT discount like individuals and trusts.
To set up a company, you would seek the advice of a tax professional. Companies have initial set up costs, ongoing advice and administration costs.
Sometimes, investors utilise a structure with both a trust and a company, in this instance categorised as a bucket company. Trusts can own the shares in an investment company, and this allows flexibility for the on flow of income/profit to all trust members. This is not just useful for a case where there are large disparities in income and therefore tax rate. It can be especially useful for individuals who may have career breaks due to caring responsibilities where income may be redistributed.
The other case is when the trust distributes profits to the company, and the company pays the 25% or 30% tax rate. This cash is then used to invest in assets and can provide franked income in the future.
Considerations for investors
The cost of maintaining a trust and company depends on the complexity. Using different structures as tax minimisation strategies means that the savings must outweigh the costs. Here is a simple scenario:
You are a high income sole trader, earning $250,000 a year. Your tax liability is around $91,700.
If you are in a different tax structure, you’re able to distribute the income through the trust to other beneficiaries. These beneficiaries will pay their marginal tax rate on income received.
As there can be up to three individual beneficiaries in the trust, the $250,000 would be distributed between three - $83,333 each.
The tax liability would be $52,362 – a saving of $39,388. This saving outweighs the average set up costs, and the average ongoing administration.
This article considers varying tax implications for different entities. Tax is a tricky subject, so we recommend seeking professional tax advice for your individual situation.
