Tax for investors: Understanding how tax impacts returns

Jason Prowd  |  09 October 2018  |  7 min read

Key Points
  • Cost (and tax) efficient investing helps you keep more of your money earning compounding returns for longer.
  • It’s important to be know how tax is going to affect overall returns from different types of assets and investment.
  • Buying and selling investments less often can limit the amount you’ll owe for capital gains tax.

Getting a handle on what to invest in and how to go about it can be pretty complex. But one simple and important rule to go by is keep your costs in check. It’s no good hitting the jackpot with returns if you’re sacrificing a big chunk to costs. This reduces your immediate investment earnings and the total sum you have invested. And that means there’s less in the pot to can benefit from compounding returns.

No matter how savvy you are, tax on your investments will probably be more than all your other costs put together. So while it may not be the number one factor driving your strategy, you shouldn’t ignore it.

Investment returns under the microscope

To give you a little taste of just how much difference tax can make, let’s look at before and after-tax performance for property vs. shares. In the 10 years to 2016, Australian shares returned an average of 4.3% before tax per year, compared with a very healthy 8.1% for residential investment property – no surprises there. But when we look at post-tax returns for investors with the lowest marginal tax rate, they actually rise to 4.9% for shares, thanks to franking credits. After-tax returns for property, on the other hand, fall by 0.9% a year, even allowing for gearing and other deductible expenses. That’s a big difference.

Taking a gamble on gearing

Well-known as a way for Aussie property investors to get legit tax breaks, negative gearing is certainly one way to be tax efficient. But bear in mind that it only works if you’ve got the cash flow to sustain what’s essentially a loss-making investment. You’ll end up ahead on overall returns if the capital gain on your asset is greater than the annual loss you’ve sustained to get the benefit of tax deductions. And that can be a pretty big gamble to make with your investment dollars.

At Morningstar Next, our primary goal as investment professionals is to safeguard our clients’ capital. And while borrowing money can certainly turbocharge potential returns, it’s also one of the biggest investing risks and one of the surest ways to end up way behind where you started. So it’s our belief that there’s no need to take on the risks that come with debt and negative gearing to get ample investment returns.


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Ownership advantages

As the Australian tax system treats us as individuals, it makes sense to take advantage of this for tax-efficient investing. If you’re pooling money to invest as a couple for example, and one of you earns a lower salary, then who will own the investment is a no-brainer for your situation. Just put the investment in the name of the lower income partner and you should find yourself collectively better off in tax terms.

If you’re both earning a decent amount already, then your marginal tax rate on investment income could be higher than you’d be paying as a company. So, in this case, it may be worth taking on board the cost of setting up a company or discretionary trust to hold investments for you.

Why buying and selling can be a drag

Seeking tax-effective ways to manage regular income from investments is one thing. But it’s the turnover of your investments that can have just as big an impact on how much tax you’ll pay overall. Every time you sell an investment asset you’re likely to be paying trading costs and capital gains tax (CGT) too.

Chasing returns by selling one asset and buying another has its pros and cons as an investment strategy. But it’s almost certain to drag down after-tax earnings with all that CGT. That’s not to say you should never buy and sell, but being more active in how you invest comes with a real cost.

Holding steady vs changing it up

To show how this might actually play out, let’s say you invest $50k for 10 years with 7% returns distributed at the end of the term as capital gains. If your marginal tax rate is 37%, you’ll pocket $89,411 after tax.

Then look what happens when you trade 50% of your portfolio annually, then sell the lot after 10 years, with the same rate of return and tax applied. In this scenario, you’ll bank $83,197 after tax. Why? Because you’ve been paying tax each year, little by little you’ve reduced the amount that’s been earning compounding returns.

Scenario 1 is like having an interest-free loan from the ATO, giving you more money to invest for longer. Sure the tax has to be paid eventually, but in the meantime, you’ve earned 8% more from your initial investment. It’s a neat and tidy way to make your money go further, providing you can afford to give up access to that sum for the investment term.


Jason Prowd leads Morningstar Next: ready-made investment portfolios.

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© Morningstar Investment Management Australian Limited (‘Morningstar’) and any related bodies corporate that are involved in the document’s creation. Whilst all reasonable care has been taken to ensure the accuracy of information provided, neither Morningstar nor its third-party providers accept responsibility for any inaccuracy or for investment decisions by any person on the basis of the information included. Past performance is not a reliable indicator of future performance. Morningstar does not guarantee the performance of any investment. Any general advice has been prepared without reference to your investment objectives, financial situation or needs. You should consider the advice in light of these matters and if applicable, the relevant disclosure document before making any decision to invest. Refer to our Financial Services Guide for more information.

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