If you invest in the wrong assets, you’ll pay twice as much tax

Tax choices

The ultimate aim of investing is to build wealth. Current and future tax liabilities can have a significant impact on your ability to build wealth. Simply put, the less tax you pay, the more money you keep for yourself. Therefore, taxation is a major consideration.

That said, tax consequences should never drive investment decisions alone. Tax is one of many considerations so its important to not become too tax focused. Balance is the key here.

Income versus capital gain

Most growth assets provide a combination of income and capital growth.

Income is taxed at your marginal tax rate (which is 39% for people earning between $87k and $180k p.a. or 47% if you earn more than $180k p.a.). However, only 50% of any realised capital gains are taxed at your marginal rate (because if you own the asset for more than 12 months you are entitled to reduce the net capital gain by 50%).

Therefore, capital gains attract half the tax than income does.

Compare asset classes

The chart below sets out the proportion of income and capital gains you can expect from investing in residential property, an index fund (ASX200), an actively managed fund and cash. Residential property provides most of its total return in capital growth and therefore is more tax efficient.

Income versus capital

Other advantages of capital gains

There are some other advantages of investing in assets that provide most of their return in capital (not income) including:

  • You only pay capital gains tax when you sell the asset. However, income is taxed in the financial year it is received. This means that you get to reinvest the gross capital gain each year and avoid paying any tax until you sell it.
  • This chart below demonstrates that you will enjoy more than four times more growth (in dollar terms) in the fifth 5-year period ($1.1m) comparted to the first 5-year period ($237k). This illustrates the power of compounding capital growth. Quality assets require time and patience. Its that simple.

Capital growth

Excerpt from Investopoly (page  48 & 49)

Let’s compare income assets to assets that generate an overall return of 10 per cent pa each. The only difference between the two investments is the components of the return – one asset produces more income (and, therefore, less growth) than the other. As you can see from the following table, the investment that generates less income results in a lower tax expense and, therefore, a 1 per cent pa higher after-tax return. However, most importantly, the higher capital growth rate for asset two makes a massive difference on the value of the assets over the long run. Asset one is projected to be worth $1.45 million in 20 years, whereas asset two is projected to be worth $2.33 million – some $880,000 more. The point is, all things being equal, it’s very valuable to substitute less income in return for more capital growth.

  Asset one Asset two
Income 4.5% 2.0%
Capital growth 5.5% 8.0%
Tax on income @ 40% (1.8%) (0.8%)
After-tax total return 8.2% 9.2%
Value of asset in 20 years @ 5.5% pa growth: $1.45m @ 8% pa growth: $2.33m

Note that the preceding table only includes the impact of income tax. It does not include the impact of capital gains tax, which, of course, all investors will pay on any capital gains they make when they sell the investment.

The following table sets out the after-tax returns produced by each asset after paying for income and capital gains tax. The amounts shown represent the after-tax income plus capital returns. It is important to note that asset two produces a 21 per cent higher return (at $400,000 more).

  Asset one Asset two
Total after-tax returns after 20 years (minus income + capital gains tax) $1.88m $2.28m

I’m not pro-property and anti-shares

The purpose of this blog is not to promote the advantages of investing in property and suggest it’s much better than other asset classes. Not at all. I believe in a diversified approach.

The point of this blog is to help you understand how different asset classes behave differently. Like in golf, you need to select the right club for the right shot. For example, inside superannuation, Australia shares are great investments because of imputation credits and the low tax rate (15%). In your personal name, property works best (particularly whilst you are working) because its more tax efficient.

Success lies in investing in the right asset class for your stage of life, financial position and ownership structure.