Why timing is key for executives to build wealth
Too little time and paying too much tax are common concerns for executives. Nerida Cole discusses why financial strategies for executives also need to be flexible enough to cope with uncertain economic times, workplace evolutions, career pivots and modern families.
We explain several strategies to improve tax effectiveness, fallbacks to boost flexibility and at the end, offer a few tips to get you talking about your own plan.
Managing investment property debt
Over the last two decades, borrowing to buy an investment property has been a very effective way for high-income earners to build wealth. Strong returns in many parts of the residential property market, tax deductible borrowing costs, and favourable loan terms on offer to executives have all worked together to support negative gearing.
But as investors get closer to retirement, or market conditions change ― as we are seeing with the COVID 19 pandemic ― planning out how to clear the debt associated with an investment property may become an increasing priority.
From a tax perspective, paying down investment loans while still working doesn’t normally stack up. Because interest charges are tax deductible, reducing the debt also reduces the future years tax deductions. But if flexibility and freedom from debt is a greater priority it may be wise to start paying down the loan early and forego some tax benefits.
The usual fallback to extinguish this type of debt is selling the property, but this may mean losing out on future growth, or paying another hit of stamp duty if you later re-enter the property market. It can also take time to sell a property. If you do want to keep the property or need more time to sell ― but you’re stopping work ― you’ll need a source of cashflow to cover ongoing loan and maintenance obligations. That could be income from other investments, a defined benefit pension, part-time work, a spouse’s salary or – if necessary, drawing on funds held in an offset account until the property can be sold.
Withdrawing money from super to reduce the debt may not be an option if you haven’t retired or reached your preservation age. Even when super is accessible, you may need to sell some investments inside your super account to fund the withdrawal, so consider the outlook for those investments and be aware that moving money out of super’s favourable low tax environment may end up increasing your future tax burden. Seeking professional financial advice can assist you with this.
Ultimately, it will depend on your career outlook and retirement plans, level of debt, mix of assets and income, and loan structures. And with record low interest rates, you may find you’re able to cover the interest repayments until other assets – or your overall strategy – reaches maturity.
Super still remains a very effective way to build wealth
For high-income earners the mandatory superannuation guarantee may use up all – or most - of the $25,000 annual concessional contribution limit. But if your total super balance does not exceed $1.6 million and you’re under 67 years of age, you can make non-concessional contributions up to $100,000 each financial year.
These contributions don’t attract any tax on the way into or out of super, and money held inside your super account can grow with a maximum tax rate of 15 per cent tax applied to earnings. When this compares to paying your marginal tax rate on investment earnings outside super, the difference over a working life can be substantial.
Let’s consider the example of Jane, a 50-year-old executive who decides to make $100,000 worth of non-concessional contributions into super for three years in a row at aged 50, 51 and 52. This results in almost $70,000 extra in her super account at age 65*compared to if she invested that same annual surplus outside of super, where her marginal tax rate is 47 per cent. This assumes identical investments inside and outside of super. The benefit accumulates purely from paying less tax over a long period of time. (NB: This is for illustrative purposes only)
Although the tax savings can be substantial, it’s also important to factor in the lack of access. Super is not usually able to be accessed until reaching age 58 and retiring, or until age 65 if you are working. This may limit options for executives who may want to retire early – or when flexibility is a high priority.
If you can’t add any more to super, or super’s preservation limits conflict with the timeline you are working to, what can you do?
Consider building on your investments outside super
Buying investments in your personal name or in joint ownership with your spouse is the most common way to do this. But both of these ownership approaches may not be tax effective for high-income earners, as investment income will be added on top of your salary and may be taxed at 47 per cent. If your spouse is a low-income earner and is expected to remain in a low tax bracket, establishing investments solely in their name may be an option.
The longer you expect to hold investments, the more likely it is that the individual owner’s situation will change from what you first expected, potentially thwarting the tax effectiveness of your original plan. Establishing a company or discretionary (family) trust to hold investments can provide more flexibility to manage changes ― and also help families who want to hold wealth across generations. Trusts can also be beneficial for specific estate planning wishes and for individuals who face high risks of litigation, but such complex structures will add a layer of accounting and administration costs. Therefore, they are only worthwhile where there is a healthy sum to invest for the long term.
To help determine which structure, or combination may be most appropriate for your situation, it’s a good idea to talk to a lawyer and an accountant to make sure all aspects are considered.
Map out a timeline to balance your choices
Combining saving inside and outside of super alongside a well-considered debt management plan can offer the flexibility you require to make more choices – whatever that may be for you. Deciding how your cashflow is distributed amongst potential strategies can be complex. To help visualise the stages you need to manage, try drawing up a timeline that maps out life events and key milestones against sources of cashflow, investment maturity dates and when big liabilities are due.
This may include:
- anticipated income from employment
- when super become accessible for you (and your spouse)
- when school fees end
- retirement target date
- debt-free target date
- career change/tree change goals
- other big commitments, e.g. changing properties.
Because diversification can help reduce investment risk and provide a smoother level of income, your plan should also weigh up the overall mix of investments you have now and what types of investments you want to hold for the long term.
This can help identify how on track you are and where gaps may exist.
If help is needed to work through your plan and develop an overall strategy to achieving your goals, it may be worthwhile to engage a specialist adviser.
*This scenario assumes identical investments inside and outside of super, providing a moderate overall return (real return of 4.1 per cent p.a. after fees, but before tax).
Interested in learning more?
Want to learn more about super?
Whether you’ve had the same super fund or investment structure in place for some time, your personal circumstances and balance may have changed – which is why it makes sense to review your arrangements. But where do you start? By using our simple guide, we show you five key areas you should consider when comparing options, which can help make it easier to make a more informed choice about your super and determine the most appropriate solution for you.