When life gives you lemons, make income
The proposed 30% CGT floor penalises low tax-bracket investors, here is one way to minimise the damage.
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Key points
With the Federal Government’s proposed CGT reforms having progressed to the Senate, one element deserves closer attention from investors who are impacted by the proposed minimum 30% effective tax rate on capital gains. This tax rate will apply to capital gains held by an individual, even where their marginal tax rate sits well below that threshold.
For retirees holding assets in their own name, non-working spouses and those scaling back at work as they approach retirement with taxable income below $45,000, this represents a meaningful shift. Under the existing CGT regime, an investor on a 16% marginal rate previously faced an effective CGT rate of just 8% on assets held more than 12 months. After the proposed CGT changes, they would face a minimum 30% rate on indexed capital gains regardless. That can change the after-tax maths quite significantly.
At face value, the shift to CGT indexation together with the introduction of a 30% tax floor looks unequivocally bad for this investor cohort. But it does present the opportunity to rethink what return profile may be most efficient for them.
The core insight: not all returns are taxed equally
Consider two hypothetical equity portfolios, each delivering a 10% p.a. total return on a $100,000 investment held over three years, with inflation running at 3% p.a. Portfolio A has a growth focus, and returns 9% p.a. capital growth together with a yield of 1% p.a. Let’s assume that Portfolio B offered the same total return but 5% of the capital growth was converted into income (so 4% p.a. capital growth and 6% p.a. income).
The table below compares the after-tax outcomes under the proposed CGT changes for a low tax rate individual (16% marginal tax rate):
| Portfolio A (Growth focus) | Portfolio B (Income focus) | |
|---|---|---|
| Capital growth (3 years, simple) | 27% ($27,000) | 12% ($12,000) |
| Income (3 years) | 3% ($3,000) | 18% ($18,000) |
| Total return | $30,000 | $30,000 |
| Indexed cost base adjustment (3% pa, 3 yrs) | -$9,273 | -$9,273 |
| Taxable capital gain | $17,727 | $2,727 |
| CGT at 30% | $5,318 | $818 |
| Income tax at 16% | $480 | $2,880 |
| Total tax | $5,798 | $3,698 |
| After-tax return (3 years) | $24,202 (24.2%) | $26,302 (26.3%) |
| Annualised after-tax return | ~7.5% p.a. | ~8.1% p.a. |
Source: Betashares. Hypothetical example for illustrative purposes only. Assumes simple capital growth of 3 years x annual growth rate rather than annual compounding of capital growth, CPI indexation of the cost base at 3% pa and a 16% marginal tax rate. This example does not take into account any fees and costs, which may be different for the two portfolios.
Same market exposure. Same gross return. But, assuming the proposed CGT changes become law, the income-oriented portfolio delivers approximately 0.60% p.a. more after tax for this investor, purely because a greater share of the return is taxed at their actual marginal rate rather than the proposed CGT floor. Compounded over time, that gap can be material.
How covered call strategies fit in
This is where the Betashares Yield Maximiser funds, like UMAX S&P 500 Yield Maximiser Complex ETF , can become relevant. By writing covered calls over a core US equity position, these strategies effectively convert a portion of potential capital appreciation into option premium income. That income is generally distributed to investors and taxed at their marginal rate rather than the proposed CGT rate. Ideally the remaining capital appreciation tracks close to the indexed cost base to take advantage of the fact that, under CGT indexation, the capital gains amount on which tax is applied is reduced by inflation. For an investment with modest capital appreciation, it’s possible that there will be little or even no CGT applied on disposal, as discussed in this Betashares Insights piece. For the investor profile described above, that switch in return character has a direct and quantifiable benefit.
UMAX S&P 500 Yield Maximiser Complex ETF provides access to the S&P 500 index while targeting a higher income yield than the underlying index, making it worthy of consideration for investors on lower marginal tax rates ahead of any legislative change. Unlike some other covered call ETFs available in the market, Betashares Yield Maximiser funds still retain some modest upside capital participation, shielding some of the total returns from tax, given capital gains are measured against a cost base that is indexed.
It’s important to note that a covered call strategy has an inherent trade off, the additional income generated comes at the cost of capped upside. This potentially means lagging the index in strongly rising markets, albeit with lower volatility. There are no guarantees that the total return of our hypothetical Portfolios A and B above will be the same. However, for an investor in this cohort, an income focussed return may be attractive, even before you consider the potential for improved tax efficiency.
Investment implementation
Betashares offers three ETFs that implement a covered call strategy, for enhanced equity income with some potential for capital appreciation over US or Australian shares:
– UMAX S&P 500 Yield Maximiser Complex ETF
– QMAX Nasdaq 100 Yield Maximiser Complex ETF
– YMAX Australian Top 20 Equities Yield Maximiser Complex ETF
Betashares is not a tax adviser. This information should not be construed or relied on as tax advice and investors should obtain professional, independent tax advice before making an investment decision.
Hypothetical examples are for illustrative purposes only. Assumptions used may not reflect actual market conditions or individual circumstances. This information does not constitute financial, tax or legal advice. Past performance is not indicative of future performance.
The Australian Government has announced proposed changes to the operation of the capital gains tax (CGT) regime. These proposals are not yet enacted and may change. If implemented, they may affect the taxation outcomes for investors, including in respect of capital gains arising on the disposal of assets and any capital gains attributed to investors by the Fund. The proposed changes may alter the current treatment of capital gains (for example, by modifying the CGT discount or introducing alternative methods for calculating capital gains).
The potential impact of these proposals will depend on the final form of the law and the circumstances of each investor. Investors should obtain professional independent tax advice in relation to these proposals and their potential application.
There are risks associated with an investment in the Funds. An investment in the Funds should only be considered as a part of a broader portfolio, taking into account your particular circumstances, including your tolerance for risk. For more information on risks and other features of the Funds, please see the Product Disclosure Statement and Target Market Determination, both available on www.betashares.com.au.
The information contained in this article is general information only and does not take into account any person’s financial objectives, situation or needs. Investors should consider the appropriateness of the information taking into account such factors and seek financial advice. This article is provided for information purposes only and is not a recommendation to make any investment or adopt any investment strategy.
Future results are impossible to predict. Actual events or results may differ materially, positively or negatively, from those reflected or contemplated in any opinions, projections, assumptions or other forward-looking statements. Opinions and other forward-looking statements are subject to change without notice. To the extent permitted by law Betashares accepts no liability for any errors or omissions or loss from reliance on the information herein.
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