Links to the first two parts.
Part 1: Inflation
Part 2: Debt
It took me such a long time to finally complete part 2 and now here is part 3. This posts is will be relatively short because I am not going into detail of what you should actually do. It's like most of my other posts, I like to give you the idea of something and hopefully you would take that idea and make something out of it. A memorable quote I read awhile back
“Give a man a fish, you have fed him for today. Teach a man to fish, and you have fed him for a lifetime"
People like Robert Kiyosaki, Napoleon Hill and Warren Buffett gave me the power to make decisions and take control of my destiny. It was never a 'do this and do that', it was more of a 'what do you think you should do'. The power you gain today will carry you for the rest of your life and to acquire power it takes a lot of effort and determination. The sooner you learn how to 'fish', the sooner you will gain power.
A lot of people (including myself sometime ago) see taxes as something we pay to the government for the income we earn. We know we need to pay goods and services taxes, income taxes, medicare levies, duties and many others. What we do is we determine how much taxes we owe and pay it, end of story. Furthermore, we got our professional advisers to make sure we pay our taxes according to the law.
Tax systems differ in every country but the main function of a tax system is to redistribute wealth. Every country has an inequality of wealth problem among its population and the tax system functions to reduce that gap. So the wealthier people get taxed more than the less wealthier people.
This posts is NOT about what constitutes to income or deductions. It is about understanding the tax system well enough and to be able to exploit the opportunities under the law (Quoted from the definition of tax planning). Are we talking about the loopholes in the tax system? Not really. It is more about exploiting the parts of the tax systems which benefit particular groups, and doing it legally of course.
Like how Robert points out, individuals are the most highly taxed in the most of the countries and has the least incentives. In Australia, the highest marginal tax rate for individuals is 45% and for companies it is generally a flat 30%. That already shows an incentive to have your own company. Most personal incomes have limited deductions available and thus contributing to a higher tax payable.
Most of the time, individuals rely on their after-tax dollars to invest, which means the amount remaining after paying taxes is all they have to invest. Worst still, the investments do not take into account the cost of capital, which is the money forgone to undertake that investment. For example, the individuals do not get a tax break on the cost of using that money to invest. This means growth of investments are limited because eventhough investment returns are quite high, the base of investment is not large enough to capitalise on the high return percentage. To increase that base on investment, it requires leverage/debt.
Example 1
An individual earns $100 in salary income, pays 30% in taxes, leaving $70. $70 is invested and gains 10%, which increases to $77. After taxes on the $7 dollar gain, the individual is left with $74.90. You can see the individual gets taxed twice in the process.
The individual has paid $2.10 in taxes for the $7 gain which comes back to the 30% in taxes.And this relies on the salary of the individual.
Example 2
An individual borrows $70 and invests it at a 10% return. Assuming the cost of borrowing is 7%. $70 + $7 (gain) - $4.90(cost) = $72.10
The individual pays $0.63 (30% of $2.10) in taxes for a $7 gain.
The big difference between the two examples is the advantage of leverage. Example 1 shows the usual situation of how individuals use after-tax dollars to invests. The individual pays taxes at every level of income. Example 2 illustrates how an individual uses none of his/her money to invest and pays less taxes by getting a deduction on the cost of borrowing. Of course the cost of borrowing decreases the net profit of the individual, but the fact is the individual is using none of his/her own money to earn income. The lesson here is the tax benefits of using leverage.
I have to note again using leverage increases risk and every investor should consider their risk profile, investment and knowledge before taking on debt.
On a much simpler side. Australian residents should know the tax consequences of investing in real estate and equities as they are the most common. In real estate, there are tax benefits of taking on debt, main residence exemption, first home owners grant and claiming of various expenses relating in maintaining the property. If you pay close attention to the available deductions, you could be saving a lot in taxes.
For equities, it is important to understand Capital Gains Tax (CGT) and franking credits. Tax rates vary for individuals, companies and complying superannuation funds. Some gains may be entitled for a discount capital gains if conditions are met. Franking credits are credits attached to distribution by companies for the taxes they have paid for. Franking percentage varies on different distributions and investors should take note of this. Franking credits can reduce taxes and are entitled to refunds.
Although I said there were limited deductions to individuals, it is still worthwhile to take advantage of incentive when you have a family and children. Items such as the medicare levy surcharge, self-education expenses, family assistance (paid parental leave and baby bonus) and others could save individuals and their families hundreds a year.
For business owners, there are many special concessions for small business owners and rules for carry forward losses. These are the various benefits the government tries to assist businesses. Businesses create jobs and that is good for the economy and that being the reason businesses get more benefits from the government compared to individuals. There are many tax incentives for business owners so if you take time and understand them, it could again save you money.
I will understand if people find it hard to understand tax consequences at the start because of unfamiliarity of terms and facts. But the fact that taxes are such an important part of wealth it will be worthwhile spending the few hours learning it because of the simple fact it can put a lot of money back in your pocket. Having a tax consultant will be beneficial, HOWEVER, you STILL need to understand the facts and process yourself to be able to take advantage of tax benefits. Your tax consultant is here to make sure your tax return is in accordance to the tax laws not with the purpose to give you tax advice based on your financial position and investment profile.
Before I end, I would like to reiterate how saving some money here and there can make a difference. The compounding effect is significant when money is rolled over, over time.
'Real estate, tax laws and debt does not make you rich, it is the knowledge about them that makes you rich'
~deyao~
