Which is the best investment strategy for you?
What is the best way of investing spare income to create wealth – is it negative gearing into growth investments or is it ploughing more money into superannuation?
The right answer will very much depend on your circumstances and in this paper we will examine each of the key issues.
Super or gearing – case study*
Let’s look at Fred’s story. He has $10,000 of pre-tax salary each year that he wants to invest for his benefit in 20 years’ time.
He wants to invest in shares and considers these two options:
Investing in super through salary sacrifice (i.e. tax deductible)
Negative gearing – i.e. borrowing to invest such that after dividends and tax his investment will cost him the same amount each year as the superannuation option above i.e. $10,000 p.a. of pre-tax income.
Fred is on the top marginal tax rate of 46.5% and as you see in Chart 1 the gearing option returns the best result in the long term. As the value of his geared investment grows he will find that he does not have to pay out the full $10,000 a year to fund the gearing program (due to the investment income increasing) so he increases the borrowing so that it matches his costs – and this makes the investment grow faster.
Fred’s negative gearing strategy gives him a portfolio worth $841,643, over twice as much as if he had invested in super, assuming none of the investments are sold.
Originally he borrowed $240,000 but at the end of the 20 years his borrowings are nearly $1,200,000. Fred is relaxed about having investment debt of that level but many investors are not. In fact, some investors are not comfortable with any level of gearing because of the additional risks involved with borrowing money for investment.
The impact of time
While the value of the geared portfolio at 20 years is much higher than the superannuation option, in the first seven years there is much less difference between them (see table 1 below). This emphasises that gearing really is a long term strategy.
The reason the gearing option does relatively better over time is that each year as Fred increases his borrowing, there are more assets working for him, and this accelerates the creation of wealth the longer the gearing plan is in place.
Table 1: Relative value of the two options
Table 2: Relative value of the two options after Capital Gains Tax
Potential impact of capital gains tax
When you build an investment with growth assets you generate a Capital Gains Tax (CGT) liability. It is important to note, though, that you do not pay CGT until you sell the investment, and you may never do that.
But let’s assume that Fred sells all investments – how will that affect his net result?
As you can see in Chart 2, the negative gearing option has the largest CGT liability ($195,682).
Further, notice that super has been only slightly reduced by CGT. That is because super is lightly taxed on capital gains. As a result, the percentage margin of the gearing option to the super option is slashed in the early years. In fact, in year one, super is actually better than gearing, but as the quantity of assets increases due to increased borrowings over time, gearing pulls away and ends up 74% better than super at year 20.
The impact of a lower marginal tax rate
What would happen if Fred was not on the top marginal tax rate of 46.5%, but was on 31.5%? It makes no difference to the pre –CGT outcome. A ‘no CGT’ outcome is possible because Fred might never sell the investments and therefore never be liable for CGT.
A lower tax rate can make a difference, however, when CGT is taken into account, as you can see in Chart 3 when compared to Chart 2.
It’s an $11,500 tax saving for the gearing option.
Fred could improve on this result by using strategies to minimise CGT. For example, by selling down his geared investments over a number of years instead of selling them all in the one year as we have assumed in Chart 3.
Another tax minimisation strategy could be to sell his geared investments when his tax rate is lower – for example, in retirement.
So, contrary to popular belief, gearing can be better for those in lower tax brackets.
Note that the tax inside Fred’s super fund is a “flat tax” and is not dependent on Fred’s income, so it has not changed with the reduction in his tax rate.
When would you not consider negative gearing?
If your income is unreliable or highly variable
If you do not have appropriate risk insurance in place
If you are expecting high expenditure on lifestyle e.g. new house, new baby etc
If you have a short investment horizon (i.e. less than seven years)
If you have a negative view on the future of share and/or property investment markets
If you are uncomfortable with market volatility and/or borrowing money to invest i.e. can’t pass the “sleep test”
If you only want to invest in defensive assets like bonds, term deposits and cash. This is because you
would be borrowing at a high rate of interest to buy a low rate of interest.
When would you not invest extra money into super?
When you are young, as it could be 30+ years before you can access it
When you have reached the contribution limits
When you can foresee the need for increased personal expenditure
When are you best to negatively gear?
When you see a prolonged period of growth in investment markets When the prospect for interest rates is reasonably good i.e. not too high
When you can look forward with certainty to significant disposable income for some time When you need to accelerate your wealth plans
When are you best to invest surplus money into super?
When you are approaching retirement age, as the money is not locked away for too long
When your super balance is lower than you need to meet your retirement goals
When you are on a high income and can salary
sacrifice or make concessional contributions When you are risk averse and wish to invest in conservative or cash based investments
Sydney Office:
