Most of us want to pay less tax and achieving tax efficiency is a critical wealth creation tool – the less tax you pay, the more money you have to either meet your needs today or to reinvest for the future.
However one of the best ways to lose money is to let tax have a disproportionate influence on investment decision-making.
The most obvious example are the managed investment schemes which proliferated in the late 1990s and early 2000s, such as films, olives, emus and trees. It’s not to say that all investors lost money from this sector, in fact the first Crocodile Dundee movie made millionaires from many of its investors.
The problem with most of the schemes, was that investors looked at the tax benefit first and enticed by its attractiveness, treated the underlying investment as somewhat incidental.
When many of these schemes collapsed under the weight of their own debt and high cost structures, investors had indeed received the promised tax benefits, but had also lost all of their invested capital.
It’s easy to point to the specifics of managed investment schemes, however we can all let tax override our investment judgement from time to time.
For example, negative gearing into property can encourage huge borrowings and big associated risks only to save a small amount of tax and Self-Managed Super Fund trustees have been known to see the words “fully franked dividend” and look no further before deciding to buy one share in preference of another.
Reluctance to pay tax can also be damaging. In 2005 I met a senior executive of an ASX100 listed company who had been issued shares in his employer at listing. The subsequent dramatic increase in the share price meant that they came to represent 90 per cent of his entire wealth.
The need to diversify into other assets to reduce risk was obvious but he didn’t want to pay the hefty capital gains tax bill. Instead, he chose to borrow against the stock, leveraging up his lifestyle in the process. As the share price fell by more than 75 per cent during the Global Financial Crisis, not only did his capital gains tax problem disappear, but he came very close to losing everything, including his house.
To ensure that the tax tail is not wagging the investment dog, ask yourself the following questions:
• What is the expected investment return in the absence of the tax benefits?
• How does this compare with similar investments subject to similar risks?
• Would I make the investment if the tax advantages were not available, in which case they become just one aspect of total return or ‘icing on the cake’?
• Am I taking additional risks to avoid paying tax?
This article was originally published at: http://www.smh.com.au/money/tax/dont-let-the-tax-tail-wag-the-investment-dog-20141127-11v7ga.html#ixzz3KsxZPsOi