Many people are keen to reduce their taxes, which makes sense. However, in my own experience I find that many methods of reducing tax, although they allow you to reduce your tax, may have other questionable consequences.
I will talk about three methods to reduce tax in Australia, namely business expense deductions, negative gearing, and salary sacrificing.
Any business expense you have can be claimed as a deduction, thereby reducing your taxable income. For example, if you work as an accountant and you subscribe to an accounting-related magazine, you can claim the cost of this subscription and reduce your taxes. Many people subscribe to the magazine and then say, "I don't care about the costs because it's deductable." This is not a good attitude. Suppose the magazine subscription costs $100. Suppose your taxable income is $50,000 per year. Any additional dollar you earn is taxed at 30 per cent. By getting $100 deducted, your taxable income is $49,900, which means that you effectively pay $70 for your magazine and you save $30. Even though you paid less for your magazine, you are not getting it for free. You still have to pay $70 for it. You cannot therefore simply buy useless crap that you don't need to reduce your tax. The stuff you buy needs to actually be something you want or something you need. You will need to make an evaluation as to whether the benefits of subcribing to the accounting magazine is greater than $70 per year. If it is, buy the magazine. Claiming work expenses like crazy reminds me of people who always buys products if they are heavily discounted. If they see that some product is 50 per cent off at the mall, they are highly likely to buy it, even though the discounted product may still be expensive and maybe they didn't really want it in the first place.
Negative gearing is another tax dodge that people like to talk about, especially in Australia where it is very fashionable to invest in real estate. Negative gearing involves borrowing money from the bank to buy some income-producing asset (e.g. a house). If the repayments to the bank is greater than the income coming from the asset, then the difference can be used to reduce your taxable income. Many people think that by negative gearing they can simply borrow heaps of money, buy heaps of houses, and pay no taxes. But you should be very careful about doing this. To keep it simple, even though negative gearing allows you to reduce your tax per se, this reduction in tax is more than made up for by the increase in other expenses, most notably interest repayments. That is, even though you have reduced your tax debt to the government, you now have a loan debt to the bank. Even though you are paying less tax to the government, you are effectively paying a tax to the bank in the form of interest repayments. The government is happy to allow this tax dodge. Even though they lose money by allow citizens to pay less income tax, they make a lot of money simply by allowing bankers to make more money collecting interest and then taxing the profits of the banks to recoup their lost cash. There is nothing wrong with borrowing money to buy something for investment purposes. However, most people do not realize how difficult it is to come out ahead when borrowing to invest. Interest rates in Australia are very high. Mortgage interest rates are about 7 per cent now. If you borrow to invest, the banks will charge you more, probably 8 per cent or more. For you to break even, your investment will need to produce 8 per cent or more per year. This is highly unlikely. I do not know of any investment that gives 8 per cent per year with low risk. In fact, any investment that gives 8 per cent per year with low risk is probably a ponzi scheme or some other similar investment scam. Most people also underestimate just how much of a burden paying back a massive loan is. Einstein claimed that compounding interest is one of the major wonders of the world. It is definitely wonderful and pleasant if your savings or investment value went up in value exponentially due to compunding interest. However, compounding can work against you if you have debt because debt can compound over time.
Anohter tax minimisation strategy is salary sacrificing. You can salary sacrifice for many things, e.g. for a car or to put into your superannuation fund (retirement fund). I am a fan of this method as it delivers instant results and it is perfectly legal. It is also very simple as well. If you want to reduce the tax you pay, you can salary sacrifice into your super fund simply by talking to HR. A simple email can often do the job. Salary sacrificing into super works because the tax you pay in your super fund is 15 per cent. As of this year, if you earn over $37,000 per year, each additional dollar you earn is taxed by 30 per cent. If you salary sacrifice, say, $100 then that $100 will bypass income tax and go into your super fund where it will be taxed at 15 per cent rather than 30 per cent. You therefore save $15 for each $100 you salary sacrificing into your super fund. If you earn more money and each additional dollar you earn is taxed at the highest rate of income tax, which I think is 45 per cent, then paying 15 per cent instead is a massive saving.
There are three main problems with salary sacrificing into your super fund:
(1) Access to Money - The first and most obvious problem is that you will not be able to access your money until retirement. If you are in your mid-twenties (like I am) then retirement will be a long way off. You will have to wait another 40 years or thereabouts to get a hand on your money. However, super law dictates that if you are experiencing "hardship" then you allowed to access your money. When I save or invest money, much of the reason for why I do is to save for a rainy day, i.e. to save money so that I can use it if I am going through hardship. If money I earn normally is being used for that purpose (as insurance against hard times) and if it goes into super it will have tax benefits and I will still be able to use it for the same purpose, then I think it is worthwhile to put more money into super where it has a better chance of growing more with greater tax benefits.
(2) Limits on Super Salary Sacrifice - Salary sacrificing into your super fund was such a great way to reduce income tax that many people got into it. That is why the government eventually stepped in and put limits on the amount your can salary sacrifice into super. Young people can now only salary sacrifice a maximum of $25,000 per year into their super funds. Some people criticize this and say that this makes it not worth it. But I think that a little bit of a good thing is better than nothing at all.
(3) Government Risk - The biggest and most worrying risk with super is the performance. Many people are worried that super is an underperforming investment because much of super is invested in the stock market and after GFC, stock markts around the world tanked thereby destroying super wealth. However, I do not believe this is a major issue. Super funds allow you to switch your money from shares into other investments like cash. You can also start up a self-managed super fund (SMSF) and invest in anything you want, e.g. art, wine, antiques, gold, and real estate (rules may change regarding investment in exotic assets like wine). The biggest risk to performance, in my opinion, is government risk. Government may make superannuation a great investment today by giving it tax breaks, but government can also take away these benefits in the future. If the government is desperate for cash one year, who is to say it won't raid citizens' super funds? It would be politically unpopular, certainly, but it is definitely a risk. However, money outside your super fund in other investments, e.g. shares and real estate, is also subject to government risk as government can change capital gains tax, land tax, stamp duty, and so forth. Therefore, the only way you can get risk of government risk is to move your money outside of the country, which is most cases is illegal if you are doing so to dodge taxes.