If you have a debt, you are probably making repayments. Each repayment you make is probably divided into two parts: interest and principal. Indeed, technically, you are only actually making a repayment if your regular payment includes an amount that reduces the principal of your debt.
This is the case regardless of whether the interest is deductible. Let’s say you have a loan worth $100,000 and the interest rate is 6%. Each month, you pay $2,000 to the lender. Of this $2,000, $500 pays the interest and the remaining $1,500 pays off the principal.
If the loan is used for an income generating purpose (for example, it is for an investment property), you can usually claim the $500 as a tax deduction. But the $1500 is never deductible. Even if the loan is for an investment, the money used to repay the principal needs to come from your after-tax income. If your tax rate is 34.5% (icl Med Levy), as an example, you need to earn $2,290 in order to have $1500 left for a principal repayment.
For this reason, it is easier to repay principal using money that is not taxed at a very high rate. The ‘best’ tax rate is zero, and – believe it or not! – there are some times when you receive money with a zero tax rate.
One example of this is an inheritance. Let’s say your Mum has been living in her own home for the last fifty years. You are her only daughter and you will be the sole beneficiary of her estate when she dies. Basically, you will inherit that house.
Because the house is your Mum’s principle place of residence, there is no capital gains tax (‘CGT’) payable when the house is sold. This exemption continues for two years after your Mum dies. Basically, if you inherit the proceeds of that house from her estate within two years of her dying, it will be tax-free. (If you wait more than two years, you will still only pay tax on capital gains that occur after her death).
Technically, your inheritance is still ‘after tax.’ It is just that, in this case, the tax rate that applies is 0%.
You and your mum both know that she will not live forever. Knowing this, you might decide not to repay as much of your own home loan during the last few years of her life. Instead, you might decide to use the money that you would otherwise have used to repay principal to make extra super contributions. These contributions are then deductible for you, making the effective personal tax rate on them 0% (although they will be taxed at 15% in the super fund).
Again, think of an example. If you contribute $10,000 into super, you will not pay any personal tax. The fund will pay 15% tax and so you will be left with $8,500 in your fund.
If, instead, you receive that $10,000 as personal income, and your tax rate is 34.5% you will only actually receive $6,550. You could use this money to repay your loan. But you would only reduce your debt by $6,550. This is why you might prefer to save $8,500 into your super fund and use your inheritance to repay your loan. You would be wealthier.
This can be especially sensible as you get closer to your own retirement age.
This is just one example of how receiving money in a low-tax way can be a really helpful when repaying principal. There are others, and so if you would like to discuss the best way to repay your own debts, talk to us soon. It could be the best conversation you have all year!