What investors need to know about income investing and tax

As they say, death and taxes are life’s only true certainties. While applying tax to your salary is one thing, there are often a few more nuances that apply to tax on your investment income. There’s different tax treatment for superannuation, for example, or the ability to use franking credits to reduce your tax bill.

It pays to be mindful of the requirements. After all, no one wants to overpay - especially considering the cost of living at the moment – and equally, no one wants to receive an unexpected bill from the ATO.

Understanding tax implications can be key to how you allocate to income investments in your portfolio. We asked Paul Aliprandi, senior private wealth advisor for Wilsons, what investors need to keep in mind when it comes to tax and income investing.

Please note this information doesn't take into account your individual needs or circumstances. Please visit the ATO for the most up-to-date requirements or speak to a specialist for advice specific to your situation.

What are the differences from a tax perspective between earning an income from equities compared to other investment assets?

There are essentially two types of income that can be generated from equities. Firstly, the dividend income, which may carry a franking credit, and potentially a capital gain where the equity is sold for more than its purchase price.

The franking credit arises from the company paying 30% tax on its income. Under the imputation system, recipients of franked dividends generally pay tax only where their marginal income tax rate exceeds 30%. The concept of the imputation system is to avoid the double taxation of company profits.

There are complex anti-avoidance rules that can apply but in the main, an investor should steer clear of arrangements where the equities are not held at risk for a period of at least 45 days (90 days for preference shares, not including the day of acquisition or sale). For unfranked dividends, the investor’s marginal tax rate applies with no franking credit.

The sale of the equities is generally taxed under the capital gains tax regime (unless the investor is a share trader). 

 Where the equities have been held for at least 12 months (not including the day of acquisition or sale), the capital gains tax discount applies. For individuals, this is 50% and for complying superannuation funds (in accumulation phase) this is 33.3%. The investors marginal tax rate is applied to the net gain (after offsetting any carried forward losses).

In contrast, rental income, interest or bond income is taxed at the investors marginal income tax rate with no tax credits. 

Any increase in the value of the bond is taxed as ordinary income when realised.

Managed funds vary significantly in terms of what their underlying investments are. Most use a trust structure however which means franking credits and discounted capital gains can flow through to the underlying investors where applicable.

What are franking credits and how are they applied at tax time? 

In the context of a company, a dividend is said to be franked where the company has paid tax (generally at 30%) on its income that is subsequently paid to the shareholders as a dividend. The franking credit attached to the dividend is equal to the tax paid by the company on the dividend paid.

For example, let’s assume that you are the sole shareholder of ABC Limited which made a profit of $100. 

•  The profit would be taxed at 30% which means ABC pays $30 tax to the Australian Taxation Office (ATO). 
•  Given it paid tax on all of its income, it is able to declare a fully franked dividend to you (its shareholder) of $70 (ie, the remaining cash after paying the $30 tax). 
•  To calculate your income tax, you need to include the $70 dividend plus the $30 franking credit attached to the dividend in your income. 
•  Your assessable income is therefore $100. If we assume your overall average tax rate is 30% (including Medicare), this would equate to a tax liability of $30. 
•  However, given the dividend was fully franked, you are allowed a credit for the $30 tax paid by ABC that reduces your tax. Accordingly, you will have no further tax to pay on the dividend. 
•  For those on the highest (47%) marginal income tax rate the additional tax will be $17 (or 24.28% of the cash dividend paid).

What are the tax implications of realising a capital gain from selling an investment asset to use for income? 

Where an individual sells an investment, any gain or loss is dealt with under the capital gains tax provisions. If the asset has been held for at least 12 months (the ATO does not include the day of acquisition or sale), the capital gains tax discount applies. For individuals the discount is 50%, for complying superannuation funds it is one-third (33.3%). 

 The investors marginal tax rate is applied to the net gain (after offsetting any carried forward losses). The discount is not available where the investor is a share trader and the asset sold is an equity position.

For example, a parcel of 100 ABC Limited shares is bought for $3,000 (including brokerage) in January 2022. The same parcel is later sold in May 2023 for $5,000 (after deducting selling costs), the investor has made a gross capital gain of $2,000. 

In this example, the investor was not a share trader and held the parcel for more than 12 months, they are therefore entitled to the 50% capital gains tax discount. The net capital gain to be included in their assessable income is therefore $1,000. This is taxed at their marginal income tax rate.

For investors using an investment property as part of their income stream, what are some tax implications to be mindful of?

Whilst rental income is assessable, with no franking credits unlike equities for example, there are a number of tax deductions that can offset the income to reduce the tax payable. 

 These include property related outgoings such as council rates, repairs, interest on any loan to buy to property together with depreciation and capital allowances. 

It is important that proper records are kept of these deductions and most importantly that accurate records of any loans are kept to ensure the correct amount of interest is claimed as a deduction. The ATO believes that nearly 9 out of 10 landlords are incorrectly claiming rental property deductions. Problems commonly occur where personal drawdowns are made against a facility that was originally fully deductible or where a loan is refinanced and increased with an additional non-deductible component. Claiming the correct proportion of the interest is important.

For investors relying on rental income they need to be mindful that the actual cash yield is the gross rent less these aforementioned expenses (apart from the depreciation and capital allowances). 

Vacancies can also be catastrophic where an investor is relying on the rental income to meet their retirement costs particularly as most of the outgoings continue to be due (eg council rates, land tax, water rates etc). It is also difficult to sell a portion of the property to raise capital to meet living costs.

What tax considerations should you be aware of and tracking when using foreign investment assets such as bonds, private credit, alternatives and equity as part of an income strategy?

Foreign managers won’t necessarily issue a year end tax summary outlining the tax components of the income paid or capital returned to be inserted into your tax return. If an investor is seeking exposure to these asset classes, they will need an accountant who has experience with these foreign investments. It follows that your accountancy bill might also increase reflecting these complexities.

When investing in foreign products, it is more likely that an investor will hold foreign currency at various points in time. It is important to be aware that little known provisions in the tax legislation can apply to any foreign exchange gains or losses made. Gains are treated as ordinary income (no 50% discount) and losses are treated as a deduction.

The income received by the investor may have tax deducted at the source under the foreign country’s withholding tax rules. These credits may be claimed back but only to the extent that Australian tax is payable on that income. Unused foreign tax credits are not refundable unlike franking credits. A superannuation fund, in pension phase for example, would not be able to claim back the foreign tax withheld, the investment’s yield is therefore reduced.

What are your top three tax-efficient income investments and why?

A well-considered direct share portfolio of stocks paying fully franked dividends provides the benefit of having the first 30% of any tax paid. Some investors may be entitled to a refund of franking credits, such as a superannuation fund in pension phase. Any resultant capital gain may also be taxed at half of the investors marginal income tax rate where held for more than 12 months (two-thirds for a complying superannuation entity). 

A managed fund with a focus on imputation credits can offer similar tax efficiencies.

Lastly, a portfolio of Australian hybrids (eg Commonwealth Bank (ASX: CBA), ANZ (ASX: ANZ), Insurance Group Australia (ASX: IAG)) offer tax-efficient income streams.

In considering the above, the investor’s appetite for risk needs to be carefully assessed and aligned with the portfolio.

And finally, what are the 1-2 things all income investors should be mindful of when considering tax implications

The actual investment is the most important thing to be mindful of. 

Years back, there were a number of agricultural style investments offering tax deductions and solid returns but the returns never eventuated. 

I often say, tax is not the tail that wags the dog…

The taxation rules are complicated and there is no substitute for good advice from a qualified tax accountant and financial advisor. Investors need to start engaging with advisors when building their wealth to reap the rewards in retirement from a well-constructed financial structure and strategy.   

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