One of the most important reasons to build wealth is to ensure you can live comfortably in retirement. There are few concepts you should be familiar with when deciding how to build your wealth.
Time and compounding
You must make the most of whatever time you have between when you start building wealth, and when you expect to start accessing your wealth.
Compounding refers to “interest on interest” or “earnings on earnings”.
Imagine you had a $100 investment that consistently delivered 10% per year. At the end of year one, your investment grows by $100 x 10% = $10.
At the beginning of year two, your investment balance has grown to $100 + $10 = $110.
If your investment again earns 10%, then at the end of year two it will grow by $110 x 10% = $11.
You will begin year three with $121 to invest.
The more time you stay invested, the more compounding works in your favour.
Of course, no investment pays 10% every year consistently. Returns go up and down and, for some asset classes, can be negative.
Asset classes, returns and risk
You can build wealth simply by earning money and putting it away. Alternatively, you can increase your wealth building capacity by investing in something that has a chance of paying a return.
Bank accounts and short term loans to governments are some of the main assets that are collectively described as “cash”. These are assets that have a fairly low level of risk and compared with other assets, it’s usually very easy to get your money out of the investment quickly (for instance you can get your money out of the bank via an ATM). The returns on these assets are normally very low, and are normally less than or similar to the declared official interest rates of an economy.
Bonds are loans to governments or corporations that can be bought and sold. They are generally longer term than cash assets. Being longer-term assets that can be bought and sold, unlike cash assets, they are susceptible to market risk and interest rate risk. Returns come in the form of interest payments from borrower to lender (bond holder), and capital gains (or losses) resulting from the sale of bonds.
Property can be residential or commercial. Properties are susceptible to market risk and other risks associated with buying, selling and owning property. Property is difficult, time consuming and expensive to buy and sell (stamp duty, agents, contracts etc) so compared with cash and bonds, property is harder to get your money out of quickly. Returns come in the form of rent from the tenant to the owner, and capital gains (or losses) resulting from the sale of properties.
A share is a part ownership in a company. Shares are bought and sold on stock exchanges . Because transactions are so frequent, so volumous, so regulated, standardised and heavily reported – you can see the market value of a share on a “to-the-minute” basis. You can generally buy and sell shares very easily and get your money out quickly – although how much money you get for your shares depends solely on what price the market is offering, and this may be less than you originally invested. Shares are susceptible to market risk and other risks that impact companies and their operations. Returns come in the form of dividends from the company to the shareholder, capital gains (or losses) resulting from the sale of shares and franking credits – which are a tax credit reflecting the tax a company paid on its earnings prior to paying dividends.
This is the risk that inflation increases the prices of things such as food and rent more rapidly than your investment grows in size. Why is this important? If you invest $100 today and your returns don’t outpace inflation, then when you redeem your investment you will be able to buy less with your money in the future than you can now. Effectively, your wealth has declined rather than grown. This risk is highest with things like everyday transaction accounts that don’t pay high interest.
The risk of outliving your savings. It’s a factor of life expectancy, the returns you receive on your investment, how much you put away each year and the number of years you spend saving.
This is the risk that locking in an investment in one asset prevents you from taking advantage of another. One example of this would be putting your money in a term deposit, only to have interest rates rise the following day and missing the opportunity to deposit in a higher interest rate account.
A market is a collection of buyers and sellers. Assets such as shares, bonds and property are sold every minute on financial and real estate markets. When sellers outnumber buyers, the value of assets falls. When buyers outnumber sellers, the value of assets rises. Sometimes unexpected and even misinterpreted news can cause dramatic increases in buyer and seller activity, causing market values to go up or down unexpectedly.
Sometimes markets fall in value and take years to recover. This is the main reason people often say you shouldn’t invest in risky assets unless you can leave your money invested for a long period of time.
Interest rate risk
This is the risk that changes in interest rates will impact the value of your investment. This is particularly important for government bonds. Government bonds are loans to the government. When you buy a government bond, the government makes periodic cash payments to you, of an agreed amount. If interest rates rise in the economy, you continue receiving the same cash payments. If you wanted to move your money elsewhere to take advantage of increased interest rates in the economy, you must sell the bond to somebody else so that you can invest the money elsewhere. Like all financial assets, when a lot of people are selling the same asset, this has the effect of pushing the value of that asset down.
If you buy a property, bond or share that is based overseas, you’ll most likely need to convert your money to the appropriate currency first. Any income you earn on that asset will likely be paid to you in the currency of the country where that asset is based. Also, if you sell the asset, it is likely you would receive the sale price in the currency of the country where the asset is based.
As the Australian dollar rises, holders of foreign currency would get fewer and fewer dollars for each unit of foreign currency they convert to Australian dollars.
If you convert your money to a foreign currency to buy a foreign asset, and the Australian dollar rises, then the value of that asset, in Australian dollars, falls, as does the Australian dollar value of any income that asset generates.
Unlike cash, bonds, property or shares, superannuation isn’t an asset you can buy, sell or invest in. It doesn’t have a “return” the same way those assets do and superannuation, on its own, does not have the same exposure to the same risks as those asset classes.
Rather, superannuation is a tax structure.
You can invest in cash, bonds, property, shares or other assets, by taking the money you earn in your job, and investing in those assets.
Alternatively, you could put money into your super fund, and then direct your super fund to invest in cash, bonds, property, shares or other assets. When you do this, your returns and risks follow the same patterns as those assets.
The difference is that investments made in a super fund are treated differently for tax purposes.
When you invest money directly into assets, any returns you make on those assets are taxed at your marginal tax rate. The lowest marginal tax rate for people who earn over the tax-free threshhold is 19%, and then Medicare Levy is charged on top of this. Generally, any interest, rent or dividends you earn are also included in means testing for Centrelink payments.
When a super fund invests in those assets, returns are taxed at a maximum of 15%. Returns on super funds are not means tested for Centrelink payments .
This means that if you contribute your money to superannuation and then direct your super fund to invest in certain assets, your tax and Centrelink position may be superior than if you invested your money directly into the same assets.
Furthermore, in certain circumstances, the Government also offers other incentives such as the Government Co-Contribution and Spouse Contribution Tax Offset , in return for contributing part of your after-tax income to super.
It is also possible to contribute some of your pre-tax income into super. This means that you don’t pay your marginal tax rate on that portion of your income. Contributions made from pre-tax income attract contributions tax of 15%, compared to the lowest marginal tax rate of 19% (plus Medicare Levy). This would also reduce your taxable income for Centrelink purposes.
Superannuation strategies for low tax payers
As superannuation is a favourable tax environment, some of the tax outcomes can be more beneficial to people in higher tax brackets than people in lower tax brackets. This doesn’t make superannuation less attractive for low tax payers, it’s just important to understand the different strategies to ensure you get the best outcome for yourself.
When you make an after-tax contribution, for instance, you are contributing money that you have already paid tax on. While you’re not making a tax saving on the contribution, once the money is in super, earnings are taxed favourably, as discussed above. In addition, eligible individuals would also be entitled to receive a Government Co-Contribution of up to $500, in return for making an after-tax contribution.
Even if you’re not in a high income tax bracket, it can still be worthwhile salary sacrificing. By salary sacrificing, you reduce your taxable income, so provided you’re earning more than the tax-free threshhold, you will be saving some money.
In addition, if you are receiving partial Centrelink payments, such as Family Tax Benefit Part A or B, the reduction in your taxable income could increase your Centrelink entitlement. Each of these Benefits reduces by 20 cents for each dollar of taxable income you declare above certain thresholds. So by salary sacrificing and reducing your taxable income, you could gain 20 cents per dollar in benefit payments.
Superannuation strategies for high tax payers
As superannuation is a favourable tax environment, some of the tax outcomes can be even more beneficial to people in higher tax brackets. It’s important to understand the different strategies to ensure you get the best outcome for yourself.
Salary sacrificing involves contributing part of your pre-tax income into super. When you do this, you pay contributions tax of 15%. However, if you’re earning over $87,000 per year then you could be paying 37 cents in the dollar tax, and medicare on top of that. So by diverting some of your income to your super fund, you make a significant tax saving. In addition, if you are receiving partial Centrelink payments, such as Family Tax Benefit, then the reduction in your taxable income could increase your Centrelink entitlement. Family Tax Benefit Part A, for instance, reduces by 20 cents for each dollar you earn over a certain threshold. So by salary sacrificing and reducing your taxable income, you could gain 20 cents per dollar in benefit payments. This is in addition to tax savings. Importantly, there are limits as to how much of your before-tax income can be contributed to super.
You can also make after-tax contributions, which may be particularly attractive if you’ve already reached the limit on before-tax contributions. While you’re not making a tax saving on the contribution, once the money is in super, earnings are taxed favourably, as discussed above.
It may also be worthwhile making a spouse contribution. Eligible spouse contributions attract a tax offset of up to $540 per year.
If you are reaching your contributions limits and want to contribute more, or if your partner is closer to preservation age than you are, then it may be worthwhile splitting your super contribution.