Keeping an eye on tax time

The financial services industry is a great traditionalist, with some practices continuing from year to year with no change.

A good example is year-end tax strategies, which are undertaken by many planners in June, instead of ideally being created so as to work throughout the financial year.

Confirmation that some planners leave tax issues to the end is shown by inflows in tax-effective managed investments schemes, which receive the bulk of their inflows in the last couple of months of a financial year.

In fairness, it is not always the planner who is to blame. Clients also wake up to solving tax problems in May rather than October.

GPA Matrix principal Jason Poole said a lot of planners lose sight of clients’ long-term needs by focusing on the year-end.

“The moves today are for the planner to look beyond the year-end and develop a long-term plan,” he said.

“I always replace that four-month year-end with a 20-year time frame.”

Poole said the focus is more about creating enough assets for clients’ financial goals rather than altering the plan to meet a tax issue in a particular year.

“We believe that by doing something good for the client now, you are putting in tax strategies that will help with any year-end tax problems,” he said.

“It is about looking at the big picture and not a specific event.

“We know if the end of the plan is good and it is about helping the client to reach their end goal.”

Ipac head of technical services Colin Lewis said people leave things until it is too late to create any strategies that will bring tax benefits.

“For example, to start salary sacrificing into superannuation has to be done before the income is earned, not at the end of the year when the client realises this year’s bonus was bigger than they thought,” he said.

“You have to start tax planning at the beginning of the year if you are going to create an effective outcome.”

Although perhaps extreme, Lewis said tax planning should really start on July 1 of the forthcoming year.

“I do admit self-employed people have a difficult time as they don’t always know what their income is going to be during the next 12 months,” he said.

For people that do have a tax problem for the year, they can prepay the interest on products such as margin loans, but as Lewis pointed out, that means next year’s deduction is already used up.

“The solution then is to pre-pay the next year’s interest, and this goes on until the final year of the loan, when there is no interest to pay and no deduction,” he said.

“The danger is this could happen in a year when a deduction is desperately needed.”

Poole said clients do get excited about reducing tax by pre-paying interest on margin loans.

“But it is a short-term solution as next year the same situation will arise where the client wants to reduce tax and the margin loan interest becomes the instant solution,” he said.

“It is just deferring a problem till the next year.”

While PAYG (Pay as You Go) employees have limited opportunities in short-term tax planning, high-income individuals are perceived to be greater users of end of year tax strategies.

However, Phil Gillard, principal of Arnheim Gillard Financial Consultants, disagreed, arguing these types of clients need long-term strategies the same as everybody else.

“If all you offer are short-term tax benefits, it comes at the expense of long-term wealth creation,” he said.

“What we like to do is go back to the fundamental goal, which is to create wealth with a risk-adjusted return net of tax.”

Gillard said his practice runs a five-point plan to maximise the income potential of a client.

“The most tax-effective investment strategy most clients can undertake is to get rid of non-deductible debt — home mortgages, credit cards, personal loans — and do it as quickly as possible,” he said.

“In order to do this, they have to have the right approach, which starts with maximising the client’s income potential.”

Gillard said the next step was home ownership if the client intended to live in the property for more than five years.

“It is not about buying, but the potential of long-term wealth creation through home ownership,” he said.

“Then the client should look at repaying debt, such as credit cards, where the interest is non-tax deductible.”

Gillard said before looking at making additional contributions to strategies such as superannuation, the first parts of the plan have to be in place.

“The client needs to look at paying debt with a 7 per cent interest rate before trying to earn 15 per cent taxed income (through a superannuation fund),” he said.

“Another point to consider is a mortgage-linked investment is risk free, but you say a superannuation investment is risk free?”

Gillard said the only reason for putting superannuation before debt is because of a client’s age.

“If the client is 35, then repaying debt is a priority, however, if they are 50, then salary sacrificing would be more attractive,” he said.

“This would enable them to access their superannuation at 60 tax-free and use that money to pay off any outstanding mortgage on the home.”

Thomson Playford partner Stephen Heath said superannuation was the most tax effective strategy for the year-end.

“The monumental shift in the superannuation rules of play will take the focus for tax-effective strategies with it,” Heath said.

“The focus is likely to shift from planning for short-term results to developing strategies with much longer term goals in mind, such as achieving a critical mass in superannuation and generating healthy income streams for retirement.”

Heath said the change that will now allow superannuation tax-free income streams after the client reaches 60 will be a big attraction.

But he emphasised these changes are not just for the end of this financial year, they should form part of a strategy that has 2020 as a goal.

Heath’s legal practice tends to deal with high-net-worth individuals, many of whom are small business owners, which enables them to be more flexible with superannuation strategies than the average salaried employee.

An option is a self-managed superannuation fund, but he warns that this strategy is not for the adventurous, as they can lose a lot of wealth with the wrong investments.

However, the excellent returns for Australian shares have seen balances of between $250,000 and $300,000 turn into funds worth $1.5 million, Heath said, which makes them attractive to clients wanting to top up superannuation this year.

“We are talking about strategies that are not driven in the immediate sense,” he said.

“The attractiveness of superannuation for clients between 50 and 75 is a result of a quantum shift in the rules to allow no other strategy to deliver wealth in retirement.”

The Government’s co-contribution for superannuation is another strategy for the year-end if the client is earning less than $58,000 a year, but this needs planning.

“For the salary and wage earner, this can be achieved through salary sacrificing and then put directly into superannuation,” he said.

“But they have to make the election for salary sacrificing early in the year and not in May or June, as it is not retrospective.”

The proposed superannuation changes, while being generous for this financial year, have not left investors much time to implement a strategy, with only three months left until June 30.

Lewis again said salary sacrifice can only be applied for these past few months and not every company’s payroll department will be willing to make changes for a couple of months.

“If the client wants to do salary sacrificing this year, they have to do it now,” he added.

Poole said the ability to salary sacrifice all depended on whether the client had the cash flow.

He cites a salary earner who may be on less than $40,000 a year and after expenses, such as mortgage repayments and general living costs have been made, there may be nothing left for salary sacrificing.

Poole said the key was to build an income stream for the client first from an investment strategy with quality assets.

“We push for clients to get that income stream and then they can look at gearing, which can be used for tax minimisation during the financial year,” he said.

“The level of gearing undertaken should be at a level to help the client achieve their goal.”

Poole said reviewing clients’ portfolios on a more regular basis means tax planning just happens.

“The adviser must be more focused on the goal rather than the quick fix,” he said.

“Transferring tax liability over a five-year period is a better strategy and using a variety of moves, such as share options, to make a difference to the client’s goals is preferable.”

However, Gillard warned that using sophisticated loan products as part of tax planning is only useful if the cost of borrowing is low.

“Tax-effective investments are often highly geared. Push the tax law envelope and they are all too often highly structured and engineered,” he said.

“This translates to a high cost product, which benefits the product provider first and the client last.”

Gillard said this includes a lot of structured products that are designed to avoid margin calls, but the investor pays a lot for that privilege.

“A margin loan with an attached protected loan requires a 16 per cent plus return just to break even,” he said.

“That’s a big ask considering that Australian equities have only returned about 10 to 12 per cent for more than 100 years.”

Gillard said these protected loans have to be looked at over five years or more and are not something to slot into the portfolio as a year-end tax strategy.

“Clients risk harm to their long-term wealth creation just because a tax opportunity pops up,” he said.

“Before going down the tax-effectiveness route with clients, the real question you need to ask is not whether a product is tax-effective, but whether it is cost-effective.”

When tax planning, investors need also to be careful when investing into managed funds, Lewis warned.

“The client has to be careful investing in managed funds at the end of the financial year because the final distributions often carry a higher tax component as the manager incorporates tax items from the whole year,” he said.

“The investor needs to look at the tax arrangements in the fund to avoid incurring more tax, which might just be in a year when the client has a high tax bill.”

Managed funds will no doubt be one of the major beneficiaries of the increased flows into superannuation expected by the end of this financial year.

Heath said the growth in superannuation this year will create new challenges for people delivering advice in subsequent years.

“The volume of money being invested in superannuation and the amounts retained in funds will bring fresh challenges,” he said.

“The ability of small (superannuation) funds to access investment markets, as well as the capacity of those markets to service the demand, will be a focus in future years,” he said.

Despite the year-end strategies and investments that are proposed each year, Gillard said, at the end of the day, growing the client’s wealth is the goal.

“All too often the investor chases tax minimisation rather than wealth growth,” he said.