Investing after the Budget
Mark and Shani run through five ways to structure yourself after the tax changes.
The Federal Budget has sparked one of the biggest debates about investing, tax and wealth creation that we’ve seen in years.
While much of the discussion has focused on who pays more tax, the more important question for investors is how these changes affect the decisions you’re making today and the wealth you’re trying to build for tomorrow.
In this episode of Investing Compass, Mark and Shani unpack the practical implications of the Budget, explore the hidden trade-offs behind the policy changes, and examine what investors can do to adapt.
You can find the full article here.
A few more of our editorial team’s articles on the Budget:
One of the loudest assumptions underpinning the Budget debate is that investing is something only wealthy Australians do. The reality is very different. As younger Australians grapple with housing affordability, wage growth that has struggled to keep pace with living costs, and rising financial pressure, investing has become an increasingly important tool for building financial security.
Three portfolio decisions to consider after the Budget changes
The new tax regime could alter the relative attractiveness of different investments. We explore three portfolio decisions investors may want to consider and the trade-offs involved before making any changes.
Every Budget creates winners and losers. We look beyond the headline announcements to examine the less obvious consequences of the Government’s decisions and what they may mean for different groups of Australians.
From investment income to capital gains, readers have sent us their biggest tax questions. We tackle some of the most common areas of confusion and explain what investors need to know.
Australia doesn’t have inheritance taxes in the traditional sense, but that doesn’t mean wealth can be transferred tax-free. We explain the tax traps that can arise when passing assets to the next generation, how to avoid them and how the Budget changes impact the transfer.
You can find the transcript below:
Mark LaMonica: Thanks to PocketSmith for sponsoring today’s episode. PocketSmith tracks your spending, income, and investments all in one place so you get a holistic view of your finances. PocketSmith has a special deal for Investing Compass listeners. Get 50% off on your first two months of the PocketSmith Foundation or Flourish plans. To get your deal, go to pocketsmith.com/investingcompass, or find the link in the podcast notes.
Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances, or needs.
LaMonica: So, Shani, before we turned on the recording, we’ve been talking about slow cooking. And that is because you gave me a rice maker / slow cooker for my birthday, which is very generous.
Jayamanne: Mark has been making rice on a stove for 10 years now. So – or maybe longer.
LaMonica: I don’t know if all of the listeners are going to be as offended at that as you are.
Jayamanne: I just wanted to make your life a little bit easier.
LaMonica: Like, how do you think most white people make rice?
Jayamanne: I don’t know, Mark.
LaMonica: Probably on the stove. But anyway, now I have this rice cooker, slow cooker. I’ve used it to make rice. I’m not…
Jayamanne: I mean, what’s the quality of the rice compared to the stove?
LaMonica: Oh, it’s much better because the stove rice is very hit or miss. Because I don’t measure anything. I’m like, I don’t really control the heat. But anyway, tomorrow I’m going to do the slow cooker.
Jayamanne: Okay.
LaMonica: And Shani is trying to tell me how to do it. But we can update that on the future episode. But what both of us would like for now belated birthday gifts, our book is still selling very well…
Jayamanne: Yes.
LaMonica: …which is exciting. So, if you haven’t bought one and want to buy it, we would appreciate it. But also, anyone who has bought it, if you could leave us a review, we’d really appreciate that. So, on Goodreads or Amazon. So, it would be nice…
Jayamanne: Or Booktopia, wherever you bought your book.
LaMonica: Yeah. If you’ve read it and like it.
Jayamanne: Yeah. If you didn’t like it, maybe just email us.
LaMonica: Yeah. We have low enough self-esteem. So, we don’t need to see that in writing. But let’s get into the topic today. So, we’re going to talk about something that we’ve been talking about a lot that’s been out there in the media a lot. And that, of course, is the budget. And specifically, we are going to focus on the changes to capital gains tax. So, we’ll go through those mechanics and then we’ll provide some tips for investors.
Jayamanne: And our goal is really just to present the facts and to stay out of the politics. We’ll just say that out front.
LaMonica: Yes. Which likely won’t make anyone happy. So, we briefly mentioned the budget in a previous podcast. And we got this comment immediately. So, I made some statement that basically under most scenarios, your taxes are going up. And somebody very much disagreed with that and pointed out that at 3% inflation, you would pay the same tax if you held on to investment for 13.7 years.
Jayamanne: So, what do you think about that?
LaMonica: I mean, I was kind of confused about the whole thing because the government modeling has said that people will pay more capital gains tax. Like that’s the intention. So, I was a little surprised about it.
But let’s get into today’s episode. And for people that have not heard, or at least maybe don’t know the specifics, Shani, why don’t you go through what actually is happening. So, maybe just walk through what’s happening with capital gains tax.
Jayamanne: Okay. So, at the time of recording, the first thing to state is that it’s still a proposal. We are recording this on the 28th of May and the measure was introduced to Parliament. So, it might not be a proposal for long, but it still isn’t law. There are two major changes being introduced to how capital gains is treated. The first is replacing the 50% long-term capital gains discount with a discounting method based on indexation.
LaMonica: And the 50%, just to explain that, that 50% discount means that if you held a share for more than a year, only 50% of that capital gain would have tax applied to it. So, very simply, if you buy a share for $100, it went up to $200, that capital gain is $100. Under the 50% discount method, you would have your marginal tax rate applied to half of that capital gain, which of course is $50.
Jayamanne: And the indexation method means if you hold a share for more than a year, the discount is based on inflation. The way that discount is applied is your cost base is adjusted upwards by the level of inflation for each year that you hold the share. So, in Mark’s example, the cost base is $100, and if inflation was 5% for a year, the cost basis would now be $105. That would reduce your capital gains for tax purposes from $100 to $95.
LaMonica: And one thing I think that’s important to go through, because I did get an email question about this, is the inflation actually compounds. So, if you had 5% inflation for two years, your cost basis wouldn’t be $110. It would be $110.25. And obviously, over time, that isn’t a big difference, but over time, that difference will increase from the compounding.
Jayamanne: Yeah. So, the fact that inflation compounds is probably underappreciated by people, it is why inflation is such a problem. Even low levels of inflation compounds over time, which is why it is so important to invest.
LaMonica: So, that’s the first big change, Shani. The second change is the 30% minimum tax rate on capital gains. So, that tax rate applies to – you can still discount, so there will still be a discounted capital gain, as we said, using that indexation method. But that 30% tax rate applies to people that basically fall into two different tax brackets. So, people with taxable income between $0 and $18,200 are in the 0% marginal tax rate. People with taxable income between $18,201 and $45,000 are in the 16% marginal tax rate. So, both of those groups will now pay 30% tax on capital gains.
Jayamanne: And it’s important to point out that the discounting will still apply. So, depending upon the impact of indexation on the capital gains, the effective rate tax rate will be lower than 30%, although likely still much higher than they would have paid under the old tax approach.
LaMonica: And obviously, if we look at those two marginal tax rate brackets, so that primarily impacts retirees and then younger investors who potentially are still students or partially in the workforce are just starting out.
Jayamanne: All right. So, those are the changes to capital gains taxes. The question now is what investors should do about this? And the short answer and first place we’re going to start is to emphasize that while under most scenarios, investors will be paying more in capital gains tax, this isn’t a reason to not invest and that is still the best way to build wealth.
LaMonica: And we do want to say this because there is a lot of commentary out there where people are wondering what the point is of even investing anymore. And I do think that that’s being a little bit overly dramatic because ultimately what is the actual alternative? You don’t refuse to work because your salary gets taxed? And so, I think people need to keep that perspective. And so, the alternative, I guess, is just keeping your money in the bank. And that is not a way to build wealth and financial freedom. And you’ll actually get less wealthy over time as inflation eats into the purchasing power of the money in the bank.
Jayamanne: And we know that this is really discouraging and it’s a discouraging time for many investors, but keeping focused on your goals, and even if you need to adjust the approach you take to achieve them, it still is achievable.
LaMonica: So, the first tip we have for investors is something that we haven’t mentioned today and that is super. And the reason we haven’t talked about super is because there have been no changes to how super is taxed.
Jayamanne: The relative value of super’s tax concessions are based on the tax environment outside of super. Taxes have increased outside of super, which makes super more attractive.
LaMonica: So, get as much money into super as possible, as long as of course those restrictions inherent in super align with your financial goals. If your financial goals have a super and non-super component, get as much money into super early and then deal with that non-super component later in life. And that will actually give those tax benefits that are inherent in super a longer time to compound.
Jayamanne: And I think this is an important thing to emphasize. Compounding or earning a return on a return is a secret to building wealth. The key element in compounding is time and over the long term, even small differences in returns can have a large impact on what you end up with. Taxes reduce returns, so all things being equal, the priority is to invest in a lower tax environment because it means in the future you will end up with more money.
LaMonica: The relative attractiveness of super also comes into play in our second tip. But first, we need to talk about how capital gains are treated under the new tax law versus dividends. So, franked dividends are now treated even more favorably from a tax perspective than capital gains.
Jayamanne: And we can run through a scenario that outlines the difference. So, Mark outlines these scenarios in an article he wrote, and it might be easy to see them in the article. So, we’ll link that, but we will give it a shot on the podcast. Consider a scenario where you bought shares and they didn’t appreciate at all during the five-year holding period. Instead, $1,000 of fully frank dividends were paid.
The pre-tax returns are the same as if the shares doubled in price over the five-year period. The franking credit in this scenario is $429. At a 37% marginal tax rate and 2% Medicare levy, net tax payable is $128 compared to $282 for the same return coming from capital gains.
LaMonica: And it is important to always remember that all returns are not equal. In the scenario that Shani just went through, the after-tax gain for a return entirely made up of capital gains is 71.8%. For a return entirely made up of dividends, it’s 87.2%. So, a franking level of approximately 38% is needed for the same tax owed on dividends and capital gains in that scenario Shani went through.
Jayamanne: And we should be clear that this is not a realistic scenario, as returns generally come from both dividends and capital gains for most Australian shares. Yet the way dividends and capital gains are treated on a relative basis under the tax regime do have implications on the approach investors should take. This is reinforced given the 30% minimum tax on capital gains, which reduces the attractiveness of waiting until retirement to realize capital gains.
LaMonica: Okay, that was a very long preamble to our next tip.
Jayamanne: Yes.
LaMonica: But it’s important and people will hopefully figure that out. And our next tip is about something called asset placement. And asset placement refers to the optimal tax environment for each type of investment. So, there are several different structures investors can take advantage of, including trusts, a corporate structure, super or just a fully taxable account outside of super.
Jayamanne: So, today we’re going to focus on super and fully taxable accounts as they’re the most widely used investment structure. As our example showed, there’s a clear delineation between the way franked dividend income and capital gains are treated. And this disparity in tax treatment has several implications.
LaMonica: So, in our first tip, we talked about the best place to hold assets is super. But investors that are holding assets inside of super and outside of super should – and that generally happens if you have a specific goal like early retirement – that’s where you should focus on asset placement. If you have both those buckets, where do you put certain assets?
Jayamanne: So, shares have a high likelihood of returns mostly consisting of capital gains and they should be in a lower tax environment in super. Shares with a higher likelihood of returns mostly consisting of franked dividends should be outside of super.
LaMonica: And that same principle applies to assets with higher expected levels of capital gains and lower expected levels of capital gains. So, growth assets like shares should be in super, defensive assets like cash and fixed interest should be outside of super.
Jayamanne: And this shouldn’t change your overall asset allocation. But if your financial circumstances allow you to decide which assets are held in which tax environment, choose the lower tax environment for assets with higher potential returns.
LaMonica: And I put a chart together in my article, the one that Shani referenced earlier. And basically, I went through and I applied that same logic. So, you want to hold growth shares in super, Australian income shares outside of super. Global shares in super, since they don’t have franked dividends. REITs should be held in super since their distributions aren’t eligible for franking credits. Cash and bonds outside of super since they have lower long-term expected returns. Things like gold and bitcoin inside of super since there is no income component and all of their returns are from capital gains.
Jayamanne: And obviously, this only applies to some investors with flexibility about where to place their assets. And people should not take this as a call to not invest in certain assets outside of super. And as we said, you need to keep investing to build wealth. But if you have a choice, just be aware of the different environments that you are investing in.
LaMonica: Exactly. Yeah, they’re not rules. They are just things to consider if you do have those choices.
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LaMonica: We’re on to our last tip, Shani, and it’s a pretty simple one. Hold shares for longer. And we are both proponents of longer holding periods because it does provide the opportunity for a thesis to actually play out instead of all the short-term noise that influences share prices. So, the new way that capital gains are taxed also makes long holding periods more attractive. The old tax approach encouraged a one year holding period to capture those capital gains discounts. Things have shifted in the new environment for non-super assets. Longer holding periods now provide discounts based on the constant erosion of purchasing power from inflation. So, if you want bigger discounts, hold shares for longer. And I have a few charts in the article that shows this visually. But I think most people should get the point.
All right. So, those are our three tips. Focus on super, be aware of asset placement and the value of long-term holdings. But we did want to address one more discussion point about the tax changes that’s getting a lot of play in certain quarters, especially in the AFR.
Jayamanne: The headline of the article was investors face 50% more tax than Treasury says. So that is a fairly extreme headline.
LaMonica: Which I think we both appreciate. We try to get people to…
Jayamanne: …open articles.
LaMonica: Exactly. Exactly. Hopefully, read them, but open them just like buy our book. You don’t have to read it. You can use it as a coaster.
Jayamanne: You can. We got a picture of someone using it as a coaster.
LaMonica: Yes, I believe an Aperol Spritz was on it.
Jayamanne: Yes.
LaMonica: So, another use for it.
Jayamanne: But using the same argument, we’ve also heard that individual stock holdings will become a thing of the past and everyone will just own index ETFs.
LaMonica: Okay. Well, so frankly, that kind of seems like it’s happening anyway with this big shift into ETFs. But let’s go through this argument that was in the AFR article. So, the basis for these claims is the different ways gains and losses are treated under the tax proposal.
So earlier in the podcast, we walked through how the cost basis of a share changes under that indexation method of discounting capital gains. So effectively, you are only being taxed on real or inflation-adjusted returns. So those are just the returns in excess of inflation.
Jayamanne: However, when capital losses are calculated, a different method is used. Only nominal losses can be used to offset gains. So, if $1,000 in shares was sold for $500 after five years of 3% annual inflation, the capital loss would be $500 and not $659 as it would be if the cost basis was adjusted by inflation.
LaMonica: The concern that many people have is that if you have shares and that share has a nominal gain, but it has a real or inflation-adjusted loss, you don’t get any credit for that.
So, let’s go through an example. So, let’s say you own a share that appreciated a total, so not every year, but a total of 5% in five years and over that five-year period, there was 3% annual inflation. So, the shares are now worth, if you started out with $1,000 are now worth $1,050 and that’s great, but you’ve actually lost money on an inflation-adjusted basis. So, if you sold those shares, you would get no capital loss to offset a gain and that’s the concern that if that scenario happens in a portfolio, then investors are going to run into trouble.
Jayamanne: And in a portfolio where there are a few outsized winners and several shares that are just meandering along and not delivering returns that outpace inflation, the effective tax rate on the total portfolio may be higher than it would be if the tax rules used inflation to index real capital losses. So, could this be 50% higher than Treasury indicates, Mark?
LaMonica: I mean, obviously, because I can make up anything I want, right? I can create any sort of portfolio and run any sort of scenarios to get to that 50% higher rate, right? So, I think what this ultimately does, it all comes down to what scenario you actually have. But yes, I do think it’s plausible that the rates are higher than the modeling that Treasury put out, but it’s impossible to know how any individual will be impacted. So yeah, who knows if this will happen to you.
Jayamanne: And you know, the ETF question is interesting as well. In an index tracking ETF that holds a basket of shares, the same impact wouldn’t occur as the gains and losses would be offset within the structure of the ETF and only the net capital gains or losses distributed to investors.
However, index tracking ETFs are almost always more tax efficient than a portfolio made up of individual shares. So, on a relative basis, they may be more attractive, which may mean investors take a different approach.
LaMonica: And I think another thing, obviously, to look at this is, it depends on what type of investor you are. So, the size of this impact from this anomaly between capital gains and capital losses, the way you calculate them, it’s all based on the types of companies in your portfolio. So historically, about 50% of Aussie share returns have come from dividends. So, under that scenario, you still get that benefit of franking credits. For investors holding shares that don’t pay franked dividends, so like global shares, or maybe more speculative Aussie shares, the tax hit will be higher. This will also likely be the case for investors if they hold thematic ETFs that frequently imbalance and distribute those capital gains to investors.
Jayamanne: And we know this was a slightly longer episode than typical, but lots to talk about with the capital gains tax changes. We do want to end where we started and reiterate that investing is still the best way to build wealth over the long term and gain financial freedom. In many ways, the share market is more attractive now given the level of housing prices and the changes with negative gearing. We know many people may be discouraged, but persistence is an unappreciated quality with building wealth. Now is one of those times where you need to keep at it.
LaMonica: All right. Thank you guys very much for listening. We really appreciate it.
Invest Your Way
A message from Mark and Shani
For the past five years, we’ve released a weekly podcast and written on morningstar.com.au to arm you with the tools to invest successfully. We’ve always strived to provide independent, thoughtful analysis, backed by the work of hundreds of researchers and professionals at Morningstar.
We’ve shared our journeys with you, and you’ve shared back. We’ve listened to what you’re after and created a companion for your investing journey – Invest Your Way. Invest Your Way is a book that focuses on the investor, instead of the investments. It is a guide to successful investing, with actionable insights and practical applications.
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