Gearing is the name we use whenever we borrow to make an investment. An investment financed with debt, at least in part, is sometimes described as a ‘geared investment.’
As you may be aware, how you make an investment – the investment ‘vehicle’ – is often a more important decision than what you invest in. Buying the same asset in a different vehicle can mean an enormous difference in the eventual return on that investment.
There are various forms of investment vehicle, including things like family trusts and private companies. For many people, especially business owners, superannuation is an ideal investment vehicle. The good news is that many business owners can borrow the money that they invest into super on behalf of the business owners.
When a business makes a super contribution on behalf of an employee, that contribution is a deductible expense of the business. And the person who runs the business can often qualify as an employee of that business. For this to be the case, the business needs to run through a separate legal entity, usually a company (on its own or as a trustee of a trust). The company is the official employer of everyone working in the business – including the people who ultimately own the company.
This means that super contributions made on behalf of the people who own the company (who are also usually directors of the company) are usually a legitimate expense of the business.
So, what has all this got to do with gearing? Well, a business can borrow to pay any of its legitimate expenses. This includes super contributions. And using debt often allows a business to make a super contribution that it could not otherwise afford. Like all business debt, provided the loans are properly organised, the interest is tax deductible. If a business is doing well, this might mean that the actual cost of the interest on the debt is reduced by 47%, which is the top marginal tax rate.
What’s more, the super contribution will reduce the business’ profit, which reduces the amount of tax paid by the business. Let’s look at an example.
Virat and Samantha operate their cleaning business through a family trust, with a company as trustee. The company is on track to make $200,000 profit in the current financial year. This means that the trust will distribute $100,000 to each of Virat and Samantha. They will each pay about $27,000 in tax on this amount – nearly $54,000 in total.
If the company instead makes a super contribution of $20,000 for each of Virat and Samantha, the share of profits on which they pay tax will drop to $80,000 each. This will reduce the couple’s tax bill by $15,600. So, they borrow $40,000 but pay $15,600 less tax. This means that the actual increase in indebtedness is only $24,400.
The $40,000 in contributions is taxed at 15% in the super fund. $6,000 in tax paid is paid there. Thus, the couple save $9,600 in net tax. They also now hold an asset worth $34,000 that they only had to borrow $24,400 to acquire.
Finally, the interest on the debt of $24,400 is deductible at the couple’s effective tax rate of 30% (as it is outside of super), while the earnings on the money invested within the super fund are only taxed at 15%. This creates a nice ongoing arbitrage.
In summary, the couple borrowed $24,400 and used the tax they did not have to pay to contribute $40,000 into super. The super fund paid $6,000 in tax. This left the couple with new debt of $24,400 and a new asset worth $34,000.
Obviously, there are I’s that need to be dotted and t’s that need to be crossed in order to get the tax treatment right. What’s more, there needs to be a strategy to eventually repay the debt. A simple way to do this is to make repaying the debt your first retirement priority. When it comes time to withdraw from your super, you can use some of the money withdrawn to repay the debt.
Remember, in the above example, the couple would only have to withdraw $24,400 to retire the debt. This leaves $9,600 in the fund.
The strategy can be especially effective when (a) you have not made much use of super so far; and (b) you are close to retirement age – the repayment can happen sooner, which can bring peace of mind. We reckon Roger Federer will be all ears when he hears about this one.