Carbon Tax Compensation Present Opportunity to Salary Sacrifice into Superannuation

To compensate for the impact of Julia Gillard's carbon tax on the cost of living, income tax cuts will compensate anyone who earns less than $80,000. For further details about the tax cuts, see the following: Individual Income Tax Rates (ATO website)

Basically, the tax free threshold will increase from around $6000 to about $18000 and instead of being taxed 15% after that, you will be taxed 19%. For each dollar you earn above $37,000, instead of being taxed 30%, that marginal tax rate will increase to 32.5% and then eventually to 33%.

What this means is that, for those who earn between $37,000 and $80,000, you can cut your income tax by 33% (rather than just 30%) if you salary sacrifice. One option is to salary sacrifice into your superannuation fund. Money that goes into superannuation is taxed, of course, but it is only at 15%.

Be careful when you salary sacrifice into your superannuation fund as there is a limit. For younger people, there is a concessional contribution limit of $25,000 per year. It is best that you speak to a financial advisor if you are concerned about exceeded this limit.

Personally, I have taken this as an opportunity to salary sacrifice more into my superannuation fund. All it involved was sending an email to HR requesting it. I now salary sacrifice $600 per fortnight into my superannuation fund.

My reasons for salary sacrificing into my superannuation fund are not just monetary. There are also some personal reasons why I am doing what I am doing. I find that having too much money around doesn't help and actually makes me worried or anxious, so putting money aside (so that it is out of sight and out of mind) actually calms me considerably. Instead of doing something stupid with the money and losing it, it is now safely stored away in my superannuation fund, and I don't have to worry about it until I'm very old.

Some people argue that putting money into superannuation when you're young is a waste of money. They argue that superannuation funds invest money in the stock market, which underperforms residential real estate. They would prefer to be hit with the higher tax and then put the money into residential real estate (by paying off their mortgages). The problem with this argument is that is assumed two things: the first thing it assumes is that superannuation funds invest only in the stock market and not real estate. This is wrong. Superannuation funds typically offer investors with the choice of a range of investments, but typically industry super funds tend to offer shares, bonds, listed property, and cash. These investments, in my opinion, are fine. But if you are absolutely desperate to invest in residential real estate, you can set up a self-managed super fund (SMSF) and invest in residential real estate. The benefit of salary sacrificing into your superannuation fund is that you can save on tax, but it is wrong to assume that superannuation funds only invest in the stock market. The second assumption is that residential real estate outperforms the stock market. This is not true. Residential real estate is very hard to measure but most studies done on this topic find that a broad Australian stock index is roughly the same in growth as residential real estate over the last few decades. Of course, you can always cherry pick some story about some guy who purchased some home for x amount and then sold a few years later for ten times the amount. Likewise, you can pick and choose select stocks like Westfield and Fortescue Metals and launch the same story in favour of the stock market, but what this teaches you is that past returns mean nothing. Just because something has performed well in the past, it doesn't mean it will perform well in the future, and in the world of finance it tends to be the opposite: i.e. those assets that go up in price rapidly in the recent past tend to be overvalued, and a correction in the form of rapidly decreasing prices usually proceeds.

In other words, there is no solid evidence that residential real estate will outperform the stock market in the long run. The best we can do is to diversify across many types of investments, from the stock market, to cash, to bonds, and even listed property and maybe some residential real estate as well. Ecclesiastes 11:2 states the following: "Divide your portion to seven, or even to eight, for you do not know what misfortune may occur on the earth."

Art is a Valid Investment

A Cooper Review commissioned by the Commonwealth Government recommends that art investments in self-managed super funds (SMSF) be banned (read Artists fear super ban will destroy local industry). This, in my opinion, is a poor idea, and it makes no sense whatsoever. I am really starting to dislike the current Labor Government. They plan to slap a giant mining tax on the country and now they want to ban art investing.

Some people say that art (paintings) are not proper investments like stocks or real estate. But they are. An investment is defined as anything that can go up in value in the future. Since art can go up in value in the future, then it is therefore an investment.

Some people say that art is not a proper investment because it does not produce any income. Real estate investments produce income because you can rent the house out and get rental income. Stocks have income because companies distribute profits in the form of dividends. However, just because an asset does not produce income it does not mean it is not an investment. Arguably the world's greatest investment, i.e. shares in Berkshire Hathaway, the holding company of the world's richest man Warren Buffet, pays no dividends. All gains are in the form of capital gains. Another good investment is the safe haven asset gold, which produces no income at all, yet it has been used as an investment for millenia. If you store art in your house, it does not produce any income. However, it is possible for art fund managers to rent out the art to businesses. To see an example of this, read Smith and Hall - Why Rent Art?

Some argue that art has no real value and that people who are willing to pay millions for a painting are fools. Art has value because looking at it gives people pleasure. This is no different to, say, high-end real estate like mansions. It is also no different to stocks in companies that sell luxury goods. If people are willing to pay money to buy clothes, cars, and houses that look good, why wouldn't they also want to pay money to look at a good-looking painting?

The Temptation of High-Risk Investments

The Australian published an analysis (Cash the Safe but Sorry Option) on the performance of super fund investment options on 19 March 2010. The article strongly denounces those investors who switched from shares into cash right after the GFC, claiming that they lost because they missed out of the post-GFC rally.

In my opinion, if you are in cash, bonds, or any other safe investment and a rally occurs in a non-cash or non-bond asset and you did not have the opportunity to exploit it, you should not feel bad. The reason why is because there will always be opportunities missed. For example, last week somebody won the lottery and with it millions of dollars. Had I known which numbers to pick, I could have won millions. Should I regret it? I don't think it's worthwhile to regret not having won the lottery because there is no way I could possibly know which numbers will appear. The same applies to investments. There is a massive random component to investing that makes investment results as random as the outcome of a lottery.

The article quotes someone named Warren Chant, principal of research house Chant West, who said the following: "It ... shows the value of taking a long-term view of investment markets when faced with volatility."

This idea that holding shares for a long time wil somehow decrease risk is one of the most puzzling aspects of investment and perhaps one of the biggest cons of all time. Professor Zvi Bodie has the opinion that buying and holding shares for a long time does not reduce risk (read Critique of Buy and Hold). In my opinion, I will assume that holding shares for a long time does not decrease risk and I will wait for evidence to show me that it is true. The burden of proof is on the investment to prove to me that it can perform well. Otherwise, I will diversify. There is insufficient evidence to prove that buying and holding shares for a long time will be safer than holding shares for a day or two. One argument given is based on historical prices. Shares indices like the S&P500 and Australia's All Ordinaries have gone up over many decades. Therefore, a simple risk analysis of statistics shows that there is more upside risk than downside risk. However, this is silly. If the price of an asset goes up considerably, that is not evidence that it will continue to go up. In fact, history shows that often when prices of assets go up sharply, it is followed by a sharp fall when the bubble bursts. If you invest based on past performance, it is highly likely you will buy into a bubble.

Many mutual fund managers claim that their mutual fund of diversified shares constitutes high quality investment because share indexes have gone up a lot over the long run. However, if past performance is the best indicator of future performance, you should not invest in diversified share mutual funds. You should invest in specific shares, e.g. in Westfield Group. Today (2010) the Westfield share price is $12.20 and in 2003 it was around $2.00, which is a 510% increase. The All Ordinaries in 2003 was 2900 wheras today it is 4890, which is only a 69% increase. Therefore, Westfield shares outperformed the All Ordinaries. Mutual fund managers will likely counterargue by saying, "How would know that back in 2003 the best investment would be to buy Westfield? It's better to diversify by investing in multiple shares via a mutual fund. Westfield may have outperformed the market in the past but that is not a guarantee that the market won't outperform Westfield in the future." Exactly! And that applies to shares versus other investments like cash and bonds as well. Even if shares have performed better than bonds or cash from one period to another, how would we have known back then that shares would have outperformed bonds? Shares may have outperformed cash in the past but that is not a guarantee that cash won't outperform shares in the future. Notice how share mutual fund managers argue for diversification when arguing for diversified share mutual funds versus specific shares but ditch this same logic when arguing for diversified share mutual funds versus cash or bonds.

How to Reduce Taxes with Salary Sacrifice

A great way to reduce your tax burden is to salary sacrifice into your superannuation fund. This is not for everyone because some people need to maintain high take-home pay to sustain their lifestyles. Money going into super is taxed at 15 per cent. Your income between $6,000 and $35,000 is taxed at 15 per cent. Hence it only makes sense to salary sacrifice into super once you earn over $35,000 and you're taxed at 30 per cent on each additional dollar.

To use an example, a person earning $46,000 a year can salary sacrifice $11,000 so his taxable income is $35,000. This means the maximum amount he is taxed is 15 per cent. He saves $2755 and sacrifices only about $200 to $300 per fortnight in take-home pay. Saving $2755 per year may not seem like much but if we assume this person is aged 25 and will retire in 40 years and if we also assume the super fund can give a return of 7 per cent per year then this $2755 will become $41,254 during retirement.

There is a limit to salary sacrifice. Recent changes by the Rudd Government mean that the maximum you can salary sacrifice is $50,000. Once you earn over $85,000 then you will have to think up another way of reducing tax. One possible way is negative gearing. But we'll cross that bridge when we get to it.

Some people argue that salary sacrificing your money into superannuation is a bad idea because you reduce your take-home pay and your money in super is locked up till you at 65 years old. I believe that this is only a problem for me if I urgently need the money for something, e.g. if I were unemployed or if I needed money for medical treatment. However, if you are suffering from financial hardship, you can submit a form with APRA to take money from your super fund under compassionate grounds (see Super Rules That Will Save Your Mortgage). In fact, salary sacrificing into super is a better idea if you want to protect yourself against emergencies because the amount you save on taxes will allow you to save up more quickly. If you do need to access your super for emergencies, if you have salary sacrificed, you will be able to access more money because you have saved on taxes.

Another argument someone made to me was that you are better off sacrificing the extra tax and getting money in your hands because you may be able to invest the money better yourself than rely on your super fund to do it. For example, you may believe it is a better investment to buy an investment property. But this assumes that you cannot invest in property through superannuation. You can by setting up a self-managed super fund (SMSF). Putting money into super doesn't affect the assets you invest in. The main difference between money in super and outside super is the tax treatment.

Australians Angry as Superannuation Funds Tank

I have been reading How to Cope with the Super Blowout. In Australia, like America, there is a forced savings policy whereby employers must give 9 per cent of income into a retirement fund. Most Australians it seems have no idea what the fund manager does with this money. They just seem to have faith in the government. Around about now annual reports are arriving in the mail telling Australians that in the last year their super fund has gone down in value by 10 to 20 per cent thanks to global financial uncertainty.

As the comments section suggests, many are not happy. Some are blaming the Rudd Government who went into power just as things started to go bad. This doesn't necessarily mean that Rudd is guilty of anything. If I walk into the house just before the vase falls and breaks, who says the vase wouldn't have fallen if I hadn't walked into the house? Some are saying buy gold. No doubt, gold has done well recently, but who says it will continue to do well. Some say buy property because it only ever goes up. This is just false. The super fund mangers are telling everyone to relax and to look at the long term.

Although I am a fan of investing my money in super, I do not like the arrogant and paternalistic policy whereby the Government thinks it is a better money manager than the average person and therefore forces a portion of income to go into investment they deem are superior. Not everyone wants to be invested in shares and long term increases in share value are not guaranteed. If they were, these gains would be arbitraged away. In my opinion, forced savings or superannuation should be done away with altogether so that regular Australians can do what they want with their money. Some say that with SMSF (self-managed super funds) individual do have control. But this is not total control. You cannot purchase a Coke with money in your SMSF.

Investing in Emerging Markets Through Sunsuper

For a long time I've been looking for a way to invest in emerging markets. Problems I usually encounter are high fees and savings plans that force you to invest, say, $100 per month. I was thinking of buying an iShares MSCI Emerging Markets ETF from the ASX but recently there has been an announcement that ETFs will be purged on the ASX. All this has left me scared to invest in ETFs.

While looking through Sunsuper's investment options I noticed that they do provide a fund that allows you to invest in emerging markets. It is the AMP Capital Multi-Manager Emerging Markets. Its MER of 0.9 per cent is fairly high compared to the other funds offered by Sunsuper, but it's quite cheap for an emerging markets fund. Another issue is that it's actively managed. Some say that active management is a plus for emerging markets.

I am thinking of putting 30 per cent of my super into emerging markets. The rest will go into the SSgA Global Index Plus, which is an enhanced index fund. There is a hedged version and an unhedged version. The AMP Emerging Markets fund is unhedged, I think. Vanguard recommends I invest half in unhedged and half in hedged if I want to get rid of currency risk. This means I'll have to invest 50% SSgA Global Index Plus Hedged, 20% SSgA Global Index Plus Unhedged, and 30% AMP Multi-Manager Emerging Markets.

I won't be modifying my super till I get a new job, so all this is just research at the moment.

The reason why I want to invest in emerging market is because I believe that if you do not have the ability to pick stocks you should simply diversify across all stocks of all companies. Why then would you not invest in developing countries since they make up 40 per cent of the world economy?

Using Salary Sacrifice and Super Contribution to Boost Net Worth

Right now I am in university (Melbourne University, if anyone is interested), which means I don't have enough time to work. As a result, I earn less than $20,000 per year. Looking at the individual income tax rates from the ATO, this means I am taxed at 15 per cent for every dollar above $6,000. I will only be charged more than 15 per cent if I earn more than $30,000 per year.

Suppose I finish university and work longer hours or get a high paying job. As a result I earn more than $30,000 and I will be taxed at 30 per cent for every dollar over $30,000. How will I fix this? Simply, I will salary sacrifice into my super fund. A Colonial First State article titled Boost Your Retirement Fund - Salary Sacrifice claims that salary sacrifice is especially good for those in the top tax bracket, i.e. those earning over $150,000 who have to pay 45 per cent on every dollar over $150,000. Taxation in Australia rises steeply as income rises. Personally I am not bothered by this, and when elections come around I always vote for the party that advocates the highest taxes. This is because, even if I earn a high salary, I can simply salary sacrifice and pay only 15 per cent income tax. The Colonial First State article claims that money going into super is taxed at only 15 per cent. This means that if you earn less than $30,000 per year, there is no point salary sacrificing into super, which is why I don't do it now.

That's not all. Once you salary sacrifice into super, you are eligible for the Government's Super co-contribution. This co-contribution is pretty much a government subsidy for saving. The maximum the Government will give you is $1,500 and this can only be achieved if you earn less than $28,980 per year. This means that you must salary sacrifice to the point where your taxable income is $28,980. Then you will not only get the maximum co-contribution ($1,500 per year) but you will minimize your income tax payments since the most you will pay is 15 per cent. Getting $1,500 from the Government may not sound like much for some, but I am 24 now and super will be paid out to me when I'm 65. Assuming my super fund grows on average 8 per cent per year, then $1,500 invested when I'm 24 becomes $35,193 by the time I'm 65. That seems like a lot!

There's another good reason why I should salary sacrifice to the point where I earn a taxable income of only $28,980. That reason is HECS. If I keep my taxable income low I won't have to repay my HECS debt. According to David Potts in Best to Wait Before HECS, I only have to pay back HECS (student loans) if I earn over $41,595 per year. Maybe people say that debt is bad and that I should repay this student debt as fast as possible. Not necessarily. Credit card debt is bad because credit cards usually charge maybe 15 per cent interest rates. However, HECS is a zero-interest loan from the Australian Government. Your HECS debt is only indexed to the CPI, which means that your debt does rise in nominal terms from not in real terms. In theory the best thing to do is to keep your money in an investment that beats inflation--shares or maybe property--and then pay back the debt just before you die. Potts says the following:

Because there's no interest accumulating, usually the longer you hold a HECS debt without having to pay any of it off, the better.

You might even hit the jackpot of never paying it off. This could be for any number of reasons ranging from the positive (an extended stay overseas or salary sacrificing into super) to the negative (you bomb out of uni and never make enough to reach the threshold).

I don't know whether it is necessary that you pay back this loan before you die. Perhaps you never have to pay this loan back if your income never goes above the compulsory repayment threshold. If that is the case then I can just let this debt accumulate till the day I die and in effect I will have received free university education. Even if it was free the education did cost me in terms of time wasted as well as cost of textbooks, petrol, and train tickets.

Update 15/5/2008:

The Australian Labor Party has announced massive tax cuts to help low income people. The Liberals call this "the politics of class envy" but I am happy since at the moment I am a low income person and even if I am a high-income person I will become a low-income person through salary sacrifice.

Thanks to these ALP tax cuts I will no longer be forced to live off $30,000 per year since the 30 per cent threshold will increase from July this year to $34,001, in July next year to $35,001, and in July 2010 to $37,001.

Some people claim that if I continue to salary sacrifice to minimize tax and to minimize HECS repayments, assuming that tax rates and HECS compulsory repayment thresholds are not adjusted for inflation, then I will have my real wage eroded in real terms over the long run. This not true because the $30,000 or so dollars of take-home pay I will get will mostly be invested in a mutual fund that I assume will rise greater than the rate of inflation.

Update 16/5/2008:

I have heard that reportable fringe benefits (i.e. amounts salary sacrificed) are included in HECS repayment threshold calculations. Therefore, this whole plan of salary sacrificing to avoid HECS may not work.

Another person, however, told me that salary sacrifice is not included in reportable fringe benefits. However, he claimed all this could change with the new Budget.

I'll probably need to talk to an expert. I hate it how tax rules are so arbitrary and complex.

Is Sunsuper The Cheapest Super Fund?

Right now I am with Hesta. They claim to have low fees but at the moment I pay administration fees of $1.25 per week and management fees of about 0.4 per cent. However, I could probably do better. If you invest in the Australian index fund provided by State Street Global Advisers at Sunsuper you pay management fees of only 0.15 per cent. The administration fee for Sunsuper is slightly higher at $1.30 per week, but that is negligible compared to the difference in management fees. If you have large amounts of money invested, the difference in costs can be massive.

I think putting money into your super fund is one of the best investments. My plan is to first have enough money outside of super to sustain my life forever in the event of job loss and family abandonment. I'll need approximately $150,000 for this, and I plan to save it up in a mutual fund outside of super. Once I have this emergency fund I will focus on building wealth within super because it is more effective. I can salary sacrifice to my super fund to the point where my taxable income is below $6,000 per year, and then I will pay no tax. Furthermore, because I will be classified as a low-income individual then I am eligible for the Australian Government's super co-contribution, which means that if I inject $1000 into my super fund, the Government will pump in another $1,500. This means I maximize my net worth given my income.

Because virtually all the fruits of my labor is locked away in my super fund, this plan is also great because it forces frugality by making me depending on the dividends of my emergency fund.

Structure Your Own Fund on Hesta and Pay Low Fees

I am with Hesta Super Fund. I didn't choose this fund. It was simply what the employer gave to me.

Most people invest in the default option, which for Hesta is the Core Pool, a diversified fund that holds a reserve to smooth out bumps. The problem with this fund is that it holds only 55 per cent of its assets in shares, which is far too conservative for someone who is 24. The rest of the fund invests in property, infrastructure, private equity, commodities, fixed interest, and cash. Wanting something more aggressive, I chose the Shares Plus Fund, which invests 76 per cent of its assets in shares. This fits in with Bogle's rule that what percentage you should invest in stocks is 100 minus your age.

The problem is that the Shares Plus Fund has a management expense ratio of 0.70 per cent (and performance fees of 0.32 per cent). This is rather high.

Luckily, Hesta has a Your Choice option that allows investors to make their own portfolios. This means I can pick and choose more specific asset classes like Australian Shares and International Shares and imitate a diversified fund like Shares Plus or even Vanguard High Growth Fund for a lower cost. So that is exactly what I did.

I decided to construct in Hesta a fund that looks exactly like Vanguard's High Growth Fund. The only problem was that Vanguard invests 7 per cent of its High Growth Fund in emerging markets and small companies. Hesta doesn't have any of these as Your Choice options. So I made an assumption that the Absolute Return Strategies option, which invests in hedge funds, is similar in risk and return characteristics.

The weighted management fee of this imitation fund is 0.55 per cent with performance fee of 0.29 per cent. This is considerably lower now!

The following asset allocations are used for the imitation fund: Fixed Interest (10%), Property (10%), International Shares (29%), Australian Shares (44%), and ARS (7%). I have copied the asset allocations used by Vanguard.

Could I do the same thing with my Vanguard fund? Right now I invest all my money into Vanguard's diversified High Growth Index Fund. However, what if I put 44 per cent into Vanguard's Australian Shares Fund, 29 per cent into Vanguard's International Shares Fund, and so on? The problem is that Vanguard doesn't offer retail funds that invest in emerging markets or small companies. Furthermore, Vanguard offers quantity discounts. I am charged 0.90 per cent on my High Growth Fund currently but for investments beyond $100,000 I am charged only 0.35 per cent. A minimum of $5,000 is also needed to start a new fund with Vanguard. All this, combined with the fact that I only work part-time, means that it is not worth it making my own fund in Vanguard. They have probably already thought about this.

Some people tell me that yet a cheaper way to invest is not through traditional mutual funds but through ETFs (exchange traded funds). This is something I'll write about more later.