Why Tax Shouldn’t Solely Drive Your Investment Decisions

Often we receive questions from investors surrounding how tax might impact their investments, and in particular, which investments they choose. While tax is an important consideration, outlined in many of our previous blogs, it’s not the only thing to consider to make when looking at which funds (and therefore provider) to choose.

“But, all the Reddit threads I read says it is!” You might be thinking… Let us explain.

There’s no denying that tax efficiency is an important part of financial planning. But choosing an investment product based only on tax efficiency is, in our opinion, a poor decision. Investment decisions must be made on the basis of your financial goals, your investment time horizon and how comfortable you are with taking on risk. Let’s unpack this a little further.

• Why is it important to specify your financial goals? – Because it will help you identify when you’ll need all or some of the invested money back (aka. investment horizon).

• Why should you care about your investment horizon? – Because knowing your investment horizon will help you land on a fund type that has a suitable asset allocation for your situation. A higher proportion of growth assets often means greater volatility. This is more suitable for a longer time horizon as you can afford to weather the market ups and downs when there is more time remaining.

• Why does your personal tolerance for risk matter? – Because it helps you stay within your comfort zone. Plus ideally stick with your investment plan when adverse market conditions come.

These factors should always be put higher up in the priority list than tax when making an investment decision. Other than that, how diversified your investment portfolio is, its past risk-adjusted returns and tracking performance are also important indicators to consider. That tracking performance might indicate or comprise some inefficient operational processes or product design. Tax savings should only be looked upon as an additional benefit.

To help you understand the additional benefits considering tax in your decision making can bring, let’s look at an example.

Ross and Rachel are a young double-income couple who want to save up for the down payment of their first home. Suppose the current value of the house that they are looking to buy is $1.75 million today. In 10 years, they are thinking it will double to be worth $3.5 million. In order to pay a 20% first home deposit in the next 10 years, they are working towards building a nest egg of approximately $700,000.

Ross and Rachel are considering two investment options to help them reach their goal. The first is a fund with an average return of 10% p.a. and a 3% tax bite (aka the amount of tax taken from your investment income) in the past 10 years.

The second is a fund with an average return of 5% p.a. and a 1% tax bite over the past decade.

Their after-tax annual income is currently $120,000 with the average annual income growth rate of 5%. They aim to save 30% of their income, on average. Here’s the snapshot of what they can accumulate under each of the two investment options:

If tax savings are driving all the investment decisions, Ross and Rachel may be compromising on the expected returns and choose the option with less tax charges. By doing so, however, they might fail to meet financial goals in time. That is, being able to pay 20% first home deposit in the next 10 years.

Now, everyone’s situation is unique. Choosing between two investment options might not necessarily be as straightforward as Ross and Rachel’s scenario. We’ve highlighted a few cases below where tax may or may not play a more significant role in your decision making.

While we know our stuff when it comes to investing, we’re not experts on tax. So, we reached out to Katrina Scorrar, Senior Tax Associate at Johnston Associates for her help explaining the more specific cases where considering tax can make a difference to your investment decisions. Here’s what she said…

The tax treatment of different investments can vary widely depending on the type of investment, and on the tax profile of the investor. A ‘tax efficient’ investment for one person might not be tax efficient for another. Understanding your personal tax profile and the tax treatment of different investments is therefore essential in evaluating the true impact tax is having or will have in relation to your investment choices.

There are a number of situations where your individual tax profile will be the more significant factor when considering the tax costs associated with different investment choices. For example, consider the following situations:

If you’re on the top tax rate of 39% then taxable income from any investment held directly in your personal name will be taxed at the higher 39% tax rate. For taxpayers in these situations a multi-rate or listed Portfolio Investment Entity (PIE) will allow them to cap the tax cost associated with that investment at 28% of the taxable income received, providing a tax saving of 11% per year when compared to investing direct.

Tax could also be reduced by holding investments via a trust where the tax rate could be capped at 33%.

When you have tax losses available then you may not have any tax to pay on investment income, as the tax losses will be deducted from your total taxable income (assuming they are not ring-fenced rental losses).

For those with tax losses the type of investment income and the tax credits generated can become important considerations. For example:

If you have tax losses you may not be able to use foreign tax credits. So, the value of those credits may be lost, while at the same time the foreign income reduces your tax losses;

Imputation credits received on dividends are not able to be refunded to you, they can only be carried forward as a tax credit to use in the future (and therefore these credits lose value due to the time value of money);

PIE income for individuals has a minimum Prescribed Investor Rate (PIR) of 10.5%. Tax losses are not able to be utilised against your PIE income. This means you could be paying tax on your investment at 10.5% (or higher if you haven’t advised the optimal PIE rate for you) and unable to utilize your tax losses.

Transitional tax residents are generally people new to New Zealand. For a period of time, they are not taxable on their overseas-sourced investment income. Therefore, there may be significant tax savings available by investing in overseas investments and foreign investment zero-rate PIEs during this period. That is, in preference to most onshore investments.

While PIE funds are generally a tax efficient structure there are situations where these may result in higher tax costs when compared to a direct investment. This is due to being taxed at a flat rate.

For example: If you recently stopped working a well paid job and your only income in NZ was $75,000 of PIE income each year, you would be taxed at a flat rate of 28% on all of the income and your tax cost would be $21,000. By comparison if you derived the same amount of income from direct investing then your tax costs would only be $15,670, due to being able to use the various marginal income tax rates.

A PIE fund can be more tax efficient when you have one-off increases in income in a tax year. For example, you may have tax to pay on the sale of a property under the bright-line rule, but your PIR does not automatically go up just because your income increases in one year. It is the lower of your total taxable income in the previous two tax years, for which you can set your rate for this year.

Likewise if your income dips for one year, such as from COVID-related factors, your PIR will remain the same until the following tax year where it can stay at the lower rate for the next two years.

The tax treatment of your investment(s) in the US and ability to utilise tax credits could increase the tax cost significantly if you factor in both New Zealand and US tax into the cost. Often PIE funds and investments in NZ shares can result in double taxation, as PIE credits and imputation credits are not generally permitted to reduce tax payable in the US on that same income.

In addition, there are often complexities in the treatment of PIEs in the US, which can lead to greater compliance costs. So, while an investment may be tax efficient in New Zealand it may not be once the US taxes and compliance costs are factored in.

The tax treatment of the investment in your home country and ability to utilise New Zealand tax credits is likely to significantly impact the total tax cost of the investment. This will depend on where you are tax resident and shows the importance of considering your worldwide tax obligations not just New Zealand.

As children don’t often have other sources of income it can be important to ensure you are maximizing the use of their lower marginal tax rates. Plus ensuring you receive the maximum benefit of any tax credits on investments.

Therefore, investments that are taxed at the correct rate such as a PIE or has refundable tax credits such as resident withholding tax on interest may be preferable to imputation credits received on dividends.

The FIF rules are essentially a form of wealth tax that can crystalize a tax liability regardless of whether you are actually receiving any income from the investments. This can cause issues with needing to liquidate investments to be able to fund the payment of tax. Plus to cover the compliance costs often associated with needing to prepare the FIF income calculations.

For more on how FIF tax works, you can read this blog.

Whilst everyone’s situation is unique and some might need to consider the impact of tax with their decision making more than others, we stand behind the notion that tax should not be your sole consideration for choosing investments, and therefore investment providers.

Understand the impact of tax and any associated compliance costs that might need factoring in, but bear in mind that it’s just one factor. There are many other factors also affecting return on investment, including risk, liquidity and the level of diversification.

That said, ultimately it’s your financial goals and investment horizon which should be the primary driver of your investment decisions and strategy.

If you would like to dig into the weeds of how tax works with investments, be sure to read our beginners guide to tax and investing here.