Growth or income? It's a taxing issue

The market’s on the move. It has been now for around eight months, and for those who have been invested it’s made for a pleasant change.

Over nearly five years of chaos on the Australian market, many Eureka Report readers exited sharemarkets because the volatility and the sleepness nights it caused weren’t worth it.

A return on cash of 5% might be boring. But boring upside, to some, is far preferable to the risk of further doing your dough.

But, here we sit in mid February, with the Australian market up more than 20% this financial year, including dividends. We’ve got cash returns at levels best described as pitiful. But if you haven’t been making some move towards growth assets (shares and property), this column is not about convincing you.

This is about the impact of tax on your SMSF and choosing an investment strategy based on growth versus one based on higher-income returns.

Returns based on income and returns based on growth are not equal. It’s not equal in general income tax law. If you make a dollar of income, you lose up to 46.5% if earned in your personal name. If you make a dollar of capital gains, it’s taxed at up to 23.25%.

However, the average salary earner will pay no more than 34% on income and 17% on the profit of an asset held for longer than a year. Capital gains are inherently more risky than income returns. In a super fund, as we know, it’s a little bit different. For complying super funds, the maximum tax rate is 15% on income and gains on assets sold in less than a year. Gains on assets held for longer than a year get a one-third discount (giving those gains an effective tax rate of 10% tax rate). Super funds in pension phase, however, are taxed at 0% on income and gains.

Whether you chase income or growth from shares is about the sort of risks that you’re prepared to take. Income from an investment tends to be far more assured than growth, as we’ve witnessed in recent years. However, what’s the impact of tax on potentially chasing one strategy over the other?

Growth, or income, from shares?

Let’s assume a couple of 50-year-old members. They’ve got $300,000 in super. They are still working, but we’re going to ignore contributions for the purpose of this example. Neither intends to take a pension from their super fund until they are at least 60.

One, however, likes the look of the “higher-growth” stocks, including BHP, Rio Tinto, CSL, mining minnows and small caps, which pay lower dividends and aim to use their capital to invest for growth.

The other investor prefers the surety of income. They like the fully-franked dividends of major banks, Wesfarmers, and real estate investment trusts and more mature, stable businesses.

Both are interested in Australian shares. We’ll assume a total return of 9%. For this example, the growth investor will receive 7% in growth and 2% in dividends, while the income investor gets 3.5% growth and 5.5% income.

We’ll also assume that no assets are sold over that period. The shares bought at age 50 are still held at age 60 (therefore removing capital gains tax for this example).

Even though the total return is the same (9%), the point of this exercise is to show you how the safety of the return of income, and therefore higher ongoing taxation, impacts on your overall portfolio value.

So what happens under these circumstances?

At the end of 10 years, the “growth” investor has grown the value of his SMSF to $690,900. The “income” investor has $658,200. The difference is about $32,700. On their existing portfolio, the growth investor has a fund that is 5% larger.

Obviously, the longer this plan runs, the bigger the benefit for the growth investor. After 15 years, the $32,700 difference has more than doubled to $73,400.

But that is assuming the same returns for growth and income of 9%. Would the growth investor really be satisfied with the extra risk he was taking on for a total return of 9%? Probably not. It wouldn’t make much sense to take the extra level of risk over an income-based portfolio for that small extra return.

The growth investor would be putting that on the line hoping for a return of at least a few per cent higher than someone taking that lower risk. But the point of this exercise is to show you the impact of tax.

(FYI: If the growth investor were to make total returns of 11%, made up of 9% growth and 2% income, then the super fund would be worth more than $829,000 at age 60, versus the $658,200 above.)

The trade-offs

There are, obviously, a few trade-offs being played here.

The first one is that the “income” investor could generally assume that they have a less volatile decade. The underlying value of their assets is far less likely to have the swings in asset value than could be expected from the growth portfolio.

The reason the growth investor is ahead is that he hasn’t paid as much tax because capital gains aren’t taxed until a CGT event occurs. If they turn on the pension at age 60, the gains can be liquidated tax-free (or continued to be held) and that’s when they would get the real benefit.

Whether you’re chasing income or growth from your shares it will largely come down to the risk you’re prepared to take.

The information contained in this column should be treated as general advice only. It has not taken anyone’s specific circumstances into account. If you are considering a strategy such as those mentioned here, you are strongly advised to consult your adviser/s, as some of the strategies used in these columns are extremely complex and require high-level technical compliance.

Bruce Brammall is director of Castellan Financial Consulting and the author of Debt Man Walking. E: bruce@castellanfinancial.com.au

• Australians are increasingly looking outside superannuation to save for their retirement years, a new study has found. According to research from the SMSF Professionals' Association (SPAA) and Russell Investments, 32.1% of respondents said they will use a different strategy to save for retirement, and of those, 72.4% said they plan to invest outside super. Confidence levels have also dropped, with 42.8% of trustees saying they are not confident about the outlook for the superannuation system due to the constant legislative changes and government tinkering. “Trustees are learning about a new risk called ‘legislative risk’,” Russell Investments chief executive Alan Schoenheimer noted. SPAA chief executive Andrea Slattery said that support for superannuation was needed from both sides of government and that it should not be treated as a honey pot by the government.
• Self-managed super funds (SMSFs) were the fastest growing segment of the superannuation sector in the past 12 months, according to the latest bulletin from the Australian Taxation Office. There were 496,207 SMSFs by the end of December, and 945,207 SMSF members. This represents a rise of 7.8% in both funds and membership over the previous 12 months. The bulletin also noted that the number of gen-X and gen-Y investors who are moving to SMSFs is on the rise. These groups now make up 71% of new SMSF members. People aged 55 and over currently dominate the SMSF market, making up 61% of all SMSF members.
• Tax concessions on superannuation are less generous in Australia than in a number of other countries with retirement systems, according to a study by investment consultancy Mercer. Mercer compared superannuation tax breaks in Australia with those in eight other countries around the world. The countries chosen for the study, as well as Australia, were Canada, Chile, Denmark, the Netherlands, Sweden, Switzerland, the UK and the US. “Our research reveals when the Australian approach is compared to countries with world-class retirement income systems, the after tax retirement benefits provided to Australians are lower than five of the eight countries,” said Dr David Knox, Mercer senior partner and author of the research.