Capital gains tax (CGT) is one of our most common taxes, but many people have no idea of its mechanics. A recent email is typical: "You answered a question from a reader about capital gains tax and suggested they tried to sell the assets over a three-year period to reduce the tax. How does that work?"
CGT is calculated by adding the capital gain to your taxable income in the financial year the sales contract is signed. If you've held the asset for more than 12 months, you may be allowed a 50 per cent discount on the gain before you add it to the rest of your income. We have a progressive tax system, which means the rate of tax increases in steps. If you earn between $45,000 a year and $120,000 a year, your marginal tax rate is 32.5 per cent. However, once your taxable income exceeds $120,000 a year the marginal rate jumps to 37 per cent and it increases to 45 per cent at an income of $180,000. As a capital gain increases your taxable income, you can see that it pays to keep your overall income for the applicable financial year within the lower tax brackets, if possible.
The idea of selling over three years, mentioned above, applies only to selling shares. It doesn't work with property because you can't sell the back bedroom. But if you have a share portfolio, you could choose to sell enough shares each year to bring in some extra income while keeping yourself within the lower tax brackets.
Another big issue here is that the tax cuts coming into effect on July 1, 2024, will change the tax brackets. From the 2025 financial year, the $45,000-$200,000 tax band rate will be a flat 30 per cent, and any income over $200,000 will be taxed at 45 per cent. If you could defer the capital gain until next financial year, you might pay less CGT.
Another way to reduce CGT is to defer selling the asset until you are in a lower income bracket. A classic example is the person who is now retired with their only income being a superannuation pension, which is tax-free.
Then there is the much-used tactic of making tax-deductible contributions to superannuation. A less well known refinement to that strategy, which can be great for retirees under 67, is to use catch-up contributions. Provided your superannuation balance was under $500,000 at 30 June 2023, in the 2024 tax year you may be able to make tax-deductible catch-up contributions right back to 2018. If you did that in the year you made a capital gain, this could give rise to a personal tax deduction of $100,000 and wipe out some CGT.
CASE STUDY: Jack and Jill are both aged 65 and have been retired for five years. Jack's superannuation is $450,000 and Jill's is minimal. They expect to sell a jointly owned investment property in the latter half of 2024 that will trigger a taxable capital gain of $400,000, and they will only have to pay tax on $200,000 of that after the 50 per cent discount. Because it is jointly owned, the gain will be split again, giving them $100,000 each. Because neither has made any concessional contributions since they retired, they have the right to "catch up" for those five years with contributions of up to $132,500 in the 2025 financial year, provided their super balances are less than $500,000 at 30 June 2024. They both make a deductible contribution of $100,000, and the CGT is eliminated.
But even if catch up contributions are not an option it's still possible to make tax deductible superannuation contributions up to $27,500 a year, including the employer contribution if any to reduce CGT. The bottom line is that a CGT event can cost you money - the better you plan for it the less money you might be required to pay.
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