Year end tax strategies - The value of sound investment

As the end of the financial year approaches, product promoters will start to release this year’s tax-effective products. For clients who find themselves with a large tax bill and little time to pay it, these products may be the only solution.

Such products are attractive to potential investors looking for large up-front tax deductions, and may also promise some level of investment performance. Yet while they may help address a pressing client need, in most cases, regular forward planning — integrated into the client’s overall investment strategy — will produce a more predictable, positive and lasting result.

There are many long-term investment strategies with excellent growth prospects that are relatively tax efficient. Some are as straightforward as superannuation salary sacrifice or Australian shares with high franking credits on dividends, to give two simple examples.

And there has never been a better time to educate your clients on the value of managing tax with an ongoing investment strategy. Given the current state of the markets, it is fairly unlikely clients will be experiencing large capital gains tax (CGT) bills due to the sale of investment assets, although they may face CGT for other reasons, such as a sale from a long-held investment property.

Traditionally, many tax strategies are left until the end of the financial year (both by advisers and their clients), with many tax-effective products receiving the majority of their inflows in the month of June. Numerous end-of-year investment strategies also focus on the tax savings that the client can get from a particular product. The focus moves away from what long-term strategy is best for your client to one of, ‘How much tax can I save right now?’.

A good strategy does more than just reduce tax

Regardless of the tax benefits of a particular strategy or investment, it should also be able to stand on its own merits for the client, not just provide a tax-effective result.

Example

Let’s consider using an investment line of credit to conservatively dollar cost average into the equity market over a 12-month period. The client is able to slowly incorporate these additional costs into their monthly budget (and stop investing earlier if they need to) as well as reduce market timing risk.

If, however, this investment were made as a lump sum and it eventuated that they could not maintain their lifestyle due to the interest cost associated with maintaining this investment strategy, they may need to sell down some of the investments to reduce their debt levels. This sell down may trigger an unwanted and/or unplanned capital gain without the 50 per cent exemption or a capital loss (potentially leaving the client with more debt than what they started with).

A good strategy is sustainable over time

A forced sale is the enemy in investment planning, as it takes the investment decision out of the client’s and adviser’s hands and makes the overall investment strategy vulnerable. The key to tax and investment planning is sustainability. Developing a sustainable plan maximises the positive effects of the chosen strategy.

By focusing on the strategy, when it comes time to make product recommendations, advisers will be selecting products that will deliver a better long-term outcome for the client. The long term in this case is aimed at the particular time horizon of the client, and is specific to each client. This may or may not mean that an agribusiness or structured tax-effective product is part of the strategy.

On the other hand, by only looking at the tax-effectiveness of the recommendations provided to clients, an adviser risks looking at only the short-term effects this strategy will have on their situation. The recommendation that is made to address the tax issue this year may not provide any tax-effectiveness in future years; it may even increase the amount of tax a client has to pay in years to come, especially on a present value basis.

Ask yourself one question: does this strategy improve the client’s net position, both now and over time?

A good strategy improves client’s net position

Crucially, the net benefit after tax of a tax-effective strategy and/or product must be greater than the contribution in today’s dollars. This must include both the tax benefit itself as well as any returns from the strategy or product. In other words, the tax benefit alone will not yield a satisfactory result.

Cash flow management is part of good tax planning

Cash flow is another important consideration in forming a tax-effective strategy. While making large lump sum investments towards the end of the financial year may work as a strategy, most clients will need to consider their ongoing cash flow, and it may be easier for them to do this each month, rather than via lump sum investing.

Regular investing smoothes tax consequences

Don’t forget that clients who invest in managed funds in May or June will bear the consequences of other investors’ CGT, as gains/losses made in earlier months are brought to account at the close of the financial year and are the responsibility of the unit holders at the end of the financial year.

By planning your recommendations so that the client has the whole year to act upon them, you are giving them greater choice and reducing market timing risk, as well as giving you, the planner, sufficient time to change and pro-actively finetune the strategy if the client’s circumstances dictate it.

Looking at a client’s complete financial situation and developing a strategy that addresses their short, medium and long-term goals should always be the basis for good advice. Tax efficiencies should come as a consequence of the strategy and not be the reason for it. It is about looking at the client’s big picture and providing sustainable strategic planning that suits the client’s needs, concerns and goals.

Rick Di Cristoforo is managing director of Matrix Planning Solutions.