Steering with gearing: building wealth for clients

Building wealth for your clients is difficult in the current economic climate, but prudent strategies, such as instalment gearing and debt recycling, can get your clients closer to their goals.

This article will outline these strategies and also consider certain issues with redraw facilities and offset accounts. It will also focus on planning for couples and Centrelink clients.

Instalment gearing

Gearing is a strategy used to accelerate wealth accumulation where money is borrowed to invest in assets that produce assessable income.

This enables your client to potentially create wealth faster than would be possible using their own funds.

When investment markets fluctuate, instalment gearing can be a sensible and disciplined strategy to build wealth over the long term. Instalment gearing is when an investor borrows to invest at regular intervals and receives the benefits of dollar cost averaging.

This approach to building wealth helps smooth the ride of short-term market volatility and has the greatest potential benefit if commenced in a bear market.

Buying at regular intervals means if the price of the investment falls, more units/shares are being purchased. As the price rises, fewer units/shares are being purchased.

A positive capital return is generated over the long term when the price of the investment rises above the average price paid over the timeframe.

As a long-term strategy, investment gearing reduces concerns about market timing and enables the power of compound returns to be harnessed.

However, instalment gearing increases the risk profile of your client’s portfolio. While gains on borrowed funds are increased from gearing, losses can be magnified in adverse circumstances.

In the case of margin loans, falling markets can create margin calls. If a client is unable to meet the margin call, some or all of the portfolio may be sold to repay the loan.

Consequently, only clients with a suitable risk profile and timeframe to invest should consider gearing.

However, a well-managed and diversified portfolio of growth assets may reduce the chance and size of any loss.

Moreover, with more funds available to invest, greater diversification can be achieved by instalment gearing.

Redraw facilities

A redraw facility allows clients to withdraw any additional capital paid off the loan principal. The Australian Taxation Office (ATO) considers any redraws from the loan principal to be new borrowings of funds. Therefore, the interest expense on any redraws will only be tax deductible to the extent the redrawn capital is used to produce assessable income (regardless of whether or not the original loan was for income- producing purposes).

Offset accounts

In contrast to a redraw facility, an offset account allows clients to park savings where the amount held in the account reduces the outstanding balance on which interest is payable. Your client is not required to declare any interest saved in the offset account regardless of the purpose for the loan.

Depositing funds into the offset account of an investment loan (that is, held for income producing purposes) decreases the interest payable and the associated tax deduction.

Conversely, withdrawing funds from the offset account of an investment loan increases the interest payable and the associated tax deduction. A tax deduction is still available even if funds are withdrawn from the offset account of an investment loan and used for non-income producing purposes.

Where the original loan is not for income producing purposes, offset account deposits and withdrawals impact the amount of interest payable, but no interest cost can be claimed as a tax deduction.

Debt recycling

If your client may be suited to gearing and has existing non-deductible debt, a strategy to consider is debt recycling. A conventional approach by many clients is to focus on non-deductible debt reduction and consider investing later. Debt recycling focuses on replacing non-deductible debt with deductible debt and investing now.

The strategy works by using equity in the home to commence a separate loan for income producing purposes — for example, a managed fund. Any income and tax savings derived from the investment (plus other sources of income) reduce the existing non-deductible home loan.

After each year (or regular period) an additional amount is borrowed to top up the income producing investment. The amount reduced from the home loan is effectively replaced with a deductible debt. This creates greater tax efficiency for the client and allows their net position (after deducting all debts) to increase over the long term.

Debt recycling, like instalment gearing, utilises dollar cost averaging to reduce timing risk and is potentially a prudent strategy in a turbulent market.

Client or partner’s name?

A common debate is whether clients should borrow to invest in the name of the lower or higher income spouse.

Where an investment is expected to be negatively geared, the spouse with the higher marginal tax rate (MTR) receives a larger tax deduction. Similarly, where the investment is expected to be positively geared, the investment may be better off in the low income earning spouse’s name.

Generally, clients do not know if the investment will be negatively or positively geared and this makes planning difficult. A key consideration is when the portfolio is eventually redeemed, capital gains tax may apply, which is smaller on a lower MTR. Consequently, gearing in the lower income spouse’s name may be an effective strategy.

Centrelink aspects

Although you may not recommend a gearing strategy for clients currently receiving Centrelink benefits, you may need to assist clients who gear and later apply for Centrelink payments.

Generally, the value of an asset under the assets test is reduced by any outstanding charge or encumbrance over that asset. For example, a margin loan of $70,000 on a $100,000 portfolio reduces the assets test assessment to $30,000 (the entire $100,000 portfolio is deemed under the income test).

Take care with home equity loans. Although they may be a cheaper source of finance than margin loans, they can create assets test problems. This is because a charge or encumbrance cannot be reduced from the value of an asset where it is secured against an exempt asset. For example, if $100,000 is borrowed using the principal residence as security to purchase a portfolio, the entire amount is assessed under the assets test.

Opportunities

Although clients may be concerned with current market volatility, sensible planning using tailored geared strategies can create wealth over the long term. Moreover, gearing provides opportunities to obtain additional funds under advice with new and existing clients.

Mark Gleeson is a technical services manager at ING.