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Smart Investing
Tax takes shine off a great year
 August 20, 2007
Robin Bowerman
There is one thing that can wipe the smile off an investor’s face faster than any other – an unexpected tax bill.
The books have been closed on the last financial year’s managed fund returns and investors will be receiving annual tax statements about now and for some the message will be bitter sweet.
For the past financial year the average return for Australia’s 14 largest share funds was 26.8%. These are funds all with more than $1.5 billion invested in them. While the total return number is almost 2% below the market index return it is still an extraordinarily good number and most investors should have had reason to celebrate.
But the gloss comes off that return when you consider the tax impacts of how the return was delivered.
For the financial year that ended on June 30 2007 these large share funds delivered 80% of their average return as income – not capital growth. So out of the 26.8% return 21.4% was distributed to investors in the form of income and only 5.4% as capital growth.
Now like it or not our tax system rewards long-term capital growth and penalises income by applying your full marginal tax rate to income and short-term realised capital gains. Australian shares is naturally a foundation asset class for investors looking for capital growth so why is so much of the market’s return being delivered in income?
If you look at the key market index the S&P/ASX 300 accumulation index the total return was 29.2%; the growth component was 24.2% and income distribution was 5%. So the broad Australian sharemarket has delivered richly and in line with the expectations of it as a long-term growth investment.
What investors are seeing in their annual tax statements may look dramatically different.
To calculate the tax bill you need the component parts of a fund’s returns. By using Vanguard’s Australian Share Index fund we can see what the tax cost would be for a top marginal rate taxpayer who invested $500,000 on July 1 2006. The investment earned a return of 28.8% for the financial year – 22.6% as growth and 6.2% as income.
On that basis (and assuming our investor had no other tax deductions) the tax bill would be $11,891.
Because after-tax returns are not reported by most fund managers it is difficult for investors and financial advisers to assess a fund’s tax efficiency over time. But if we take the top 14 Australian share funds and use their average returns and the breakup of what was distributed as income and capital growth then we can estimate what tax our top marginal rate taxpayer would pay. Out of the total return of 26.8% the income component was 21.4% and 5.4% was growth.
If the fund was highly inefficient in the sense that all of the income distribution was either dividends or short-term realised capital gains then the tax bill would jump from $11,891 to $49,081. If you change the assumption so that all of the distribution is realised long-term capital gains which is taxed at half your marginal tax rate the tax bill drops to $29,115.
If you invest via a self-managed super fund with the lower tax rates that super enjoys then the tax payable with the index fund drops to $4021 (from $11,891) while for the most efficient of the active portfolios it drops to $11,539 (from $29,115).
These figures highlight the value to investors and advisers of being able to clearly see after-tax returns. Investors on low tax rates or paying no tax would be delighted with the high income distributions.
But clearly for high marginal tax rate investors the after tax return can dramatically lower their returns – up to 9% based on last year’s numbers – depending on the style of fund you invest in. For people investing in super in the accumulation phase the tax take is less but it is still significant while for retirees drawing down an allocated pension it may be largely irrelevant – in fact their preference may be for high income generating funds.
Tax remains typically the largest cost for most investors and it dwarfs things like fund management expenses or financial planning fees yet the information is still not generally available.
Investors - and particularly advisers who have considerable influence with fund managers - ought to ask why.
More articles from this week's CompareShares newsletter:
Markets: Weathering the storm
Companies: Unloved offshore miners - part 2
Resident Trader: Running scared
International: Stronger Asia better able to deflect ripples
Credit: Eyes on central banks after US Fed move
US sub-prime: US recession on the cards
Markets: The fear spiral
Smart Investing: Tax takes shine off a great year
Stock of the week: NAB
Companies: Some transport worth catching
Software review: Amibroker
Whatever your views, you can discuss this article - or any of Robin's articles - on our message board Your 2 Cents.
Robin Bowerman is Head of Retail at index fund manager Vanguard Investments Australia and the former managing editor of Shares and Personal Investor magazines. To receive this column by email each week go to http://www.vanguard.com.au/ and register with smart investing.
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