Why chasing tax deductions is wrong!
I thought I would write a short piece on something that has come up a lot recently….. people chasing tax deductions. You probably have had conversation or thought…. “Should I spend money on this, my mates spend money on this…. it’ll save me tax!.” In some cases, people are chasing scams / advice from so called experts in the hope of getting extra deductions and saving tax. So is that a good thing?
I want to debunk some of the myths around tax deductions…. yes, spoiler alert here… Extra deductions aren’t a good thing. I know what your thinking… this guy is mad, but stick with me and read the below.
Firstly, I need to explain in very simple terms how tax works. So here are two very important things we need to know about tax to understand why chasing deductions can be a bad thing:
1. We pay tax at Marginal Rates of tax. In layman terms, this means we pay tax in brackets. For example, the first 18,200 is tax free, regardless of how much you earn. The next $18,800 is taxed at 19% plus medicare, regardless of how much you earn. It is a common misconception that as you earn more, the higher your tax rate on all income. Yes, as your income increases, you pay a higher tax rate…. but only on that extra bit, not the whole lot. The highest tax rate kicks in at $180,000 and is 45% plus medicare. So if you earn over $180,000, you will pay tax of 45% plus medicare, but only on the income above $180,000. The tax you pay on the brackets under that remains the same (at the lower rates in the table below).
* Tax Table for Resident Australians at date of publishing article. Note, Federal Budget Measures not yet approved.
So why is this important? Often I will be asked, “Should I stop earning income so I don’t go over $80,000 income bracket”….. Their assumption is that they will jump up a tax bracket and pay that rate of tax on all income. This is false – see above.
In general, you should try to earn as much as you can…. so what if you pay some extra tax, you will always be better off cashflow wise. When I delve deeper into the motivations of people, most people tell me they want more money…. so that means earning more or less deductions. Don’t be motivated by the tax.
The only legitimate argument to not earning more income is when a person says “to earn that extra money after tax is not worth my time and effort” – that is a personal decision and each person will need to assess that for themselves.
2. A deduction does not increase your tax refund by the same amount!This is important concept to understand, so let’s look at some simple examples….
Lets say someone earns $85,000 and they then earn an extra $1,000 bonus. The tax on the extra $1,000 bonus is $370 (ignoring medicare for simplicity). So the person is still $630 better off ($1,000 less $370 tax) cashflow wise than had they not got the bonus.
The same is true for deductions…… but in reverse. So lets take the same example of $85,000 of income, but this time they have the opportunity to spend $1,000 on a deduction. They will save tax of $370 (being the $1,000 x marginal tax rate). Cashflow wise, this person is $630 worse off… $1,000 spent, less $370 tax saving (extra refund). Spending $1,000 on a deduction does not get you $1,000 back in tax.
Importantly, this is true of all deductions…. if you spend money, regardless of the tax saving, you will always be worse of cashflow wise. So this also applies to negative gearing of property and shares……
Another way of looking at it is……I will often tell my clients, I can make you pay zero tax…… its simple. I write you out an invoice for the same amount as your income. You pay me that money. You get a fantastic deduction (Tax Agent Fees are deductible) and pay no tax. Would you do that??? I hope not…..
So when is a deduction a good thing (there are few)?
- When you were going to spend that money anyway – new computer for work as the old one is dead, or new power drill so-on. The cash was going to be spent anyway, so lets maximise the tax deduction.
- It is part of a long term strategy – For example, the loss of the negatively geared rental property each year will be repaid (& hopefully then some) when you eventually sell the property. So you are prepared to wear the burden of the cashflow loss each year, in the hope for an overall windfall. Which by the way, means more tax when you sell….. so we are after all chasing more income/profit.
- There is some specific tax opportunity that allows you to get a deduction and minimise tax, but not significantly burden you cashflow wise. A good example would be using superannuation deductions very close to your access age (or as part of a long term strategy). You are essentially getting a deduction for paying yourself (your super).
I have seen a number of disasters because of people chasing tax deductions, so here is my quick list of why you should not be in a hurry to chase deductions:
- Missed loans for a home or car. Banks don’t do fancy addbacks anymore and your numbers from your tax return go into the loan application. The banks logic, if you put it in the tax return, then it must be legitimate. So if you are over inflating deductions, don’t be surprised to have a loan knocked back or less borrowing capacity. Don’t shoot yourself in the foot. Think ahead – what is more important, better borrowing capability or slightly less tax? I can’t tell you the amount of times someone has ignored this advice, only to tell me they wish they had listened because now that home they wanted is just out of reach.
- Business fails to sell. Again, a client maximised their deductions, claiming excessive business use percentages on phone, internet, cars so-on. Despite making adjustments for this in the sale valuations, the buyer wasn’t prepared to accept them all. Accordingly, the client achieved a lower sale price than they would have otherwise. Similar to the bank story, put yourself in the shoes of the buyer….. for years the seller claims the same thing, but you are then told when you buy the business those costs won’t be real? Are you prepared to take that risk and pay a higher price because of it…. few buyers are. Of course, each business will be different.
- Managed Forestry Schemes – These schemes went belly up. Clients lost lots of money. Their motivation was saving tax when they bought the investment and the risky return they hoped for never eventuated. This left a very sour taste in their mouth. Some people spent $100,000 or more. If they got $45,000 back (top rate of tax) as a tax refund or reduction, they still went $55,000 backwards. Most wish they never invested….. none are happy about the tax they saved in retrospect. Trust your gut….. if it sounds too good to be true, it probably is.
- Clients spending money on a deduction, only to be cashflow poor and then struggle to pay important obligations (like a tax bill, or school fees so-on). Remember the bigger picture.
- There was a recent article in the Sunday Mail by Scott Pape the Barefoot Investor…. he recommended a person sack their accountant for suggesting an over aggressive investment strategy that boosted deductions. Don’t just take my word for it, read advice from people like this.
So do Holmans get the best deductions for my clients…… you bet we do! I go through their stuff in detail, trying to find out what we can claim. The key here is that I am looking for deductions where the clients has already decided it was a good decision to spend the money. I am not trying to convince my clients to spend money just so they can get a tax deduction.
Do I believe in tax minimisation planning – Absolutely! Again, it is about looking for sensible opportunities and only where the client will benefit overall (i.e. their super). A big part of tax planning is helping clients plan for the future too….. not one off strategies, but long term tax effective structuring. We also help clients forecast upcoming tax liabilities so they can plan cashflow wise (certainty).
My recommendation – Chase higher profits and more tax. You will have more money to spend, you will have a better lifestyle (more options anyway), better borrowing capacity and less stress over cashflow. What doesn’t sound good about that.
Hope this article was helpful.