Most people overlook their superannuation when they think of ways to increase their wealth creation, says Jonathan Philpot
While many consider negative gearing an investment property to be a tax effective way of growing their investment wealth and reducing their personal tax, it may not be the best way forward.
Indeed many are not aware that they can now make personal super contributions and claim a tax deduction for this amount.
Using gearing to build wealth can be risky and negative gearing into property carries a higher risk without a guarantee of a greater return.
A negative gearing strategy can pay off, if the value of the property appreciates enough over time to deliver a strong capital gain, but this isn’t always the outcome. In addition, the capital costs of running and maintaining an investment property can be high.
Generally speaking, people would be better off looking at making extra concessional (before tax) contributions to their superannuation as a means of lowering risk.
A common concern about superannuation is that the money is locked away and less accessible compared with other forms of investment.
While that is in part correct, property is far from an easily accessible asset. Investors can only access the capital upon the sale of the property, which can take time. Generally speaking, property is best held for at least 10 years.
At the same time, the income generated from rental is generally low – often at around 3 per cent per annum or less – and this income is often being utilised to meet loan repayments.
Irrespective of how wealth is built over a lifetime, there is no doubt that come retirement, the most tax effective place for wealth to be held is within super.
However, given the restricted concessional contribution limits of $25,000 a year that now apply, people can no longer deposit a large lump sum into super.
Instead, they need the benefit of time to build up their super balances.
Case study: A lesson in saving
Let’s take 40-year-old, Sarah, earning an income of $100,000 a year, with a superannuation balance of $100,000. Assuming Sarah’s super generates an average return of 7 per cent per annum and that her salary grows by 2 per cent a year, her balance through compulsory super alone would increase to $718,683 by the time she is 60.
If Sarah decides to buy a $500,000 investment property that is 100 per cent geared with the loan secured against her existing home, she would have upfront out-of-pocket expenses of about $20,000.
Sarah could expect to earn rental income of around $15,000 or 3 per cent per annum on the property, less annual expenses of about $5,000, giving her a net income of $10,000 per annum.
Assuming Sarah has an interest-only loan at 4.5 per cent per annum, her interest repayments would be $22,500 a year.
Sarah’s taxable income would be reduced by the $12,500 income loss on the property resulting in a personal annual tax saving of $4,763.
Assuming the property’s value would appreciate by an average of 4 per cent per annum it would be worth $1,095,562 in 20 years’ time.
If Sarah sells the property at age 60, she will have a capital gain of $556,128. After repaying the principal of the loan and allowing for tax and other expenses, Sarah would have cash available of $482,091. When added to her superannuation balance, of $718,683, her overall investment wealth is $1,200,774.
However only $718,683 of the wealth is held within super and so would be relying on the current contribution rules to still be in place, and it would take her a number of years to contribute the $482,091 into super.
Alternatively, Sarah could invest her $12,500 into superannuation by making an additional concessional contribution each year. She could then claim a personal superannuation deduction which would also result in a personal annual tax saving of $4,763.
The $20,000 that she would have spent in upfront property costs could also be contributed to her superannuation. By age 60 Sarah’s superannuation balance would be $1,209,011.
Sarah’s financial position in 20 years’ time would be similar under each option, however under the second scenario it is all already within the super environment and is a less risky strategy than gearing into property.
Jonathan Philpot is a partner, Wealth Management at HLB Mann Sydney
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