Using your tax refund to ‘gear’ is one way to grow your investment portfolio, while keeping it tax effective.
Gearing, or borrowing to invest, allows you to borrow against your own capital, to increase your investment and potentially maximise your investment returns.
One way for investors to do this is with a margin loan. The investor invests an initial amount of money (for example a tax refund) and will borrow an amount from the lender to invest the total in shares or managed funds.
The following example shows how this strategy can be tax effective and potentially provide a greater return:
Example – Sue and Rachel each have $100,000 to invest in a managed share fund. Sue invests her $100,000 into a fund earning 10%pa ($10,000).
Rachel invests her $100,000 in the same fund, but borrows an extra $100,000 so her total investment is $200,000, earning her $20,000pa.
The interest on her loan is $8,900 (8.9%), so her net return for the year is $11,100 – which is 11.1% of her own initial funds of $100,000.
So ultimately, Rachel’s returns are better even though she invested the same amount as Sue.
| Sue | Rachel | |
| Own initial investment | $100,000 | $100,000 |
| Funds borrowed | Nil | $100,000 |
Investment return* |
(10%) $10,000 | (10%) $20,000 |
| Loan interest | Nil | $8,900 |
| Net investment return | (10%) $10,000 | (11.1%) $11,100 |
| *Of this return, 70% is capital gain, 30% income | ||
Rachel’s gearing strategy has allowed her to invest twice as much and increase her returns – even taking the loan repayments into account.
Rachel has also bettered her tax position for the current financial year. Her current income is $70,000. While the investment income ($6,000) will be taxed at her marginal tax rate, the interest on the loan is tax deductible, bringing her taxable income down to $67,100. This gives her a tax saving of $870.
To gain a further tax deduction in the first year,
Rachel can also pre-pay her loan repayments for 12 months in advance. This means she can claim up to two year’s worth of interest (this year’s and next).
While borrowing to invest is a great way to maximise investment returns, it can only be successful if the income and capital growth of the investment exceeds the borrowing costs over the long term.
If the reverse happens and markets underperform, the investor can be left with what is known as a ‘margin call’. If the value of the initial investment falls below a certain level (which is set by the lender), you then usually have 24 hours to make up the difference with further security or by reducing your loan amount.
While gearing can maximise returns, it can also magnify losses, so margin lending is only suitable for more risk tolerant investors and those with surplus funds available to cover any margin calls.
Benefits of borrowing to invest
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Gearing helps grow your wealth faster as it allows you to invest more and as the capital of the investment grows in value, the dividends/returns may increase. |
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Although income earned from your investment is taxed at your marginal tax rate, the interest on your loan is tax deductible. |
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Interest can be paid 12 months in advance. This can be advantageous if you have capital gains you wish to offset. |
Who may be suited to gearing?
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Long term investors - 7 + years. |
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More risk tolerant investors – just as gearing can magnify gains, it can also magnify losses if markets go down. |
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Those who have capital gains – these can be offset by loan interest repayments up to a year in advance. |
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Those with a surplus cash flow to cover loan repayments if investment returns do not cover 100% of the repayments. |
Before embarking on a gearing strategy, speak to your Count adviser.
 Next: Does your portfolio need reviewing? |
As at
16 November, 2006 Doc Owner: < > |
