Taxes matter. Just don't let them drive investment decisions
27 May 2019 | Investment principles
Now that the election is over, we know that refundable dividend franking credits will continue to be available to investors.
No matter where you stand on that issue, the debate was a healthy reminder that shifting government policy is a risk that can upend a financial plan. Nearly every election, the parties propose changes to the tax code, super, health care, or the age pension to attract certain voters. And that means that nearly every election, investment decisions based on the desire for a tax deduction or any other policy may become more or less appealing.
The potential for these changes is known as tax, policy or regulatory risk.
You can never predict what the government may choose to do, so minimising regulation risk requires not letting the bright lights of tax deductions or other lures dazzle you into making a financial decision you would not otherwise make.
Which is not to say how you structure your portfolio is not important, as long as you bear in mind the core principles of investment success; identify your financial goals, select a diversified, low-cost portfolio to achieve them and stay the course, no matter what financial markets do.
With those principles guiding you, if an investment has the added benefit of a tax incentive, then it makes sense. Tax incentives, however, can’t save a bad investment. If an investment is sold primarily as a way to avoid or minimise taxes, keep your money in your wallet.
History provides all too many examples of tax-driven investments gone bad. A change to tax rules in 2007, revealed the weaknesses of certain agricultural investments (avocado and olive farms, to name two) propelled by tax breaks and hefty commissions for those who sold them.
Tax or policy-driven investments also can increase the risk of your portfolio in ways that may not be obvious. If you put money in certain shares based primarily on the desire for franked dividends, for example, you may inadvertently overexpose your portfolio to certain companies or industries.
The franking policy was designed to prevent dividends from being taxed twice — once at the company level and again when they are paid out to investors. It’s important to understand that managed funds, including exchange-traded funds, pass through franking credits to investors via end of year tax statements, something that, as the franking credit debate was raging in the run up to the election, was not well understood by investors in public seminars.
Tax and policy considerations are not irrelevant, it is important to take them into account, however it’s more important not to put them in charge. Tax deductions provide healthy additional return only if an investment helps you achieve your goals in a diversified portfolio. If not, step away from the bright lights, and enjoy the warm, enduring glow of a financial plan chosen for the right reasons.
Written by Robin Bowerman, Head of Corporate Affairs at Vanguard.
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Robin Bowerman, Head of Corporate Affairs at Vanguard Australia, shares investment and personal finance insights gained from over two decades in the finance industry as writer, commentator and editor.