Indexing

Tax-effective investing

Of all the expenses you pay as an investor, taxes have the potential to take the biggest bite out of your total return.

The amount of tax you pay depends on a number of factors including the fund type (for example, super, unit trust, pension), type of assets, your marginal tax rate and the fund manager's investment approach.

How to pay less income tax

By maximising your use of tax-efficient investments, organising your assets in the right types of accounts and employing other tax-saving strategies, you can keep more of your investment returns. Remember to keep all relevant documents so you or your accountant can calculate exactly what you owe.

Here are some tax-effective investment strategies:

• Buying & holding: If you sell shares or a managed fund you've held for one year or less, you'll have to pay tax on any capital gains at your regular income tax rate. But if you hold these assets for longer than 12 months, you may receive a discount of up to 50% on the capital gain.
• Using tax-efficient funds: Investing in funds, such as index funds, that have a low turnover (that is, they buy and sell securities relatively infrequently) can reduce your capital gains liability and improve your after-tax returns.
  
  Australian shares offer the lowest effective tax rate of all the asset classes due to the dividend imputation system. Some Australian share funds target companies with high franking levels, which can help offset the amount of tax you pay on dividends.
• Investing in superannuation: You can often make contributions from your pre-tax salary so your money is taxed at the concessional rate of 15% rather than your marginal tax rate. Contribution plans (MH asked what this meant) or salary sacrificing through your employer can be a great way to maximise your contributions and reduce the amount of tax you pay.

Do your homework before you invest

A manager's investment approach can significantly impact the amount of tax you pay at the end of the financial year.

Portfolio turnover is one of the reasons actively managed funds tend to incur higher tax liabilities for investors. Portfolio turnover reflects the level and frequency of trading in a portfolio and is an important indicator of tax efficiency. Some active managers can turnover their portfolios by 100 per cent or more in a year. By comparison, Vanguard's buy and hold approach has an average turnover rate of less than five per cent.

Generally, the higher the level of turnover the higher the probability of realising short- term capital gains. Short-term realised gains on assets held for less than a year are less efficient. Long-term capital gains are more efficient because the discounted tax rate effectively halves the amount of tax payable.

When choosing a fund, try and ascertain how the investment processes of your fund manager will impact your after-tax return. Unfortunately, comparing after-tax results is not that easy in Australia, where after-tax reporting is still not compulsory.

Morningstar currently publishes the after-tax returns of around 50 funds that voluntarily provide data. The number of participating funds is expected to increase over time.

Vanguard has been publishing the after-tax performance of its funds since October 2004. Investors can clearly see the after tax results of Vanguard's funds under four different tax scenarios.