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Finding tax-effective income sources

It’s important to recognise not all tax-effective investments are the same.



Recent changes to superannuation limit contributions and the amount self-managed super fund (SMSF) trustees can hold in the fund when it is in the tax-free pension phase. 

So it’s an idea for trustees to look more broadly for tax-effective investment strategies, to help counter the impact of these changes. 

Here, we look at a number of options for investors to generate tax-effective income.

Franking credits are one of the most popular ways for investors to generate tax-effective returns. They are attached to company dividends and allow investors to claim a tax credit for tax paid on a company’s corporate earnings. 

Low-tax or no-tax investors, which include many retirees with account-based pensions, can receive a cash payment for the difference between the franked rate of dividend income and the individual’s tax rate. This is instead of a tax credit. 

This has significant implications for income-seeking retirees and means franked dividends are extremely valuable.

According to AMP Capital’s research, retirees on a zero per cent tax rate will be able to receive an uplift of up to 43 per cent on each dollar of fully franked dividends. So for every 70 cents of dividends, investors can receive a tax credit of up to 30 cents, which equates to 43 cents per dollar of dividends.

It’s important to recognise not all investments with tax-free status are the same. For instance, fully franked dividends are worth more than capital gains and unfranked dividends. 

So if a retiree paying zero per cent tax receives $1 of capital gains or unfranked dividends, it will be worth $1 to them. But if they receive $1 of fully franked dividends, it will be worth up to $1.43.

Aside from directly investing in shares, equity income funds are one option to help generate both tax-effective income and good returns. These funds invest in shares and also benefit from the dividends and franking credits many Australian shares produce.

The latest generation of equity income funds are designed to meet retirees’ goals by paying a smooth, regular, tax-effective income from a portfolio of investments with lower volatility than the market and that rises with the cost of living. 
 
Income before tax

While reducing tax is always important, it is even more important to earn a good investment return.

“There is no point receiving a small tax deduction if it means losing your capital. This is particularly the case in superannuation where the tax rates are so low,” says Greg Einfeld, director of SMSF specialists Lime Super.

However, if you can find a tax deduction without sacrificing returns it’s an idea to take advantage of it.   

Capital gains are one opportunity, which accrue tax at a lower rate than income, as long as you hold an asset for at least 12 months.  

“In superannuation capital gains are taxed at 10 per cent, whereas income is taxed at 15 per cent. Depreciation is another opportunity. This can arise if an SMSF owns a property, and indirectly if it invests in a property trust,” says Einfeld.  

“Investments in early stage venture capital limited partnerships (ESVCLPs), a type of venture capital fund) are not taxed. But these investments might be riskier than shares due to the earlier stage of the underlying businesses in the fund,” he warns.

There is a range of opportunities to generate tax-effective investment returns. The idea is to identify solutions that will help the fund meet its long-term investment objective. 
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