Understanding tax deductions

Understanding exactly how much of what you spend is tax deductible is crucial for understanding what you can spend on your business (and when).

People often fall into the trap of thinking that spending a dollar on tax deductible expenses or assets will save a dollar in tax.

But the tax man isn’t that generous.

In fact, with the ongoing changes to marginal tax rates, there’s even less advantage given to lower income earners.

To demonstrate the point, let’s consider you as an individual taxpayer and the marginal tax rates that apply to you for the 2020-21 tax year:

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If your taxable income is less than $18,201 per year, you will not pay any tax.

So if you buy a tax-deductible subscription, for example, you won’t receive any tax benefit because you’re not going to pay any tax anyway.

But let’s say you earn more than $180,000 and you spend a dollar on the same tax-deductible subscription. How much tax will you save and get back from the tax man?

Any income earned over $180,000 attracts tax at 45 cents in the dollar (plus the Medicare levy of two percent), so a $1 tax deduction will give you a tax saving of 47 percent.

But what’s the actual cost of the subscription once tax is accounted for?

The $1 for the subscription less a 47 cents tax saving equals an out-of-pocket cost of 53 cents.

Pretty good, right? It’s no wonder those with taxable incomes over $180,000 say, “I love being in partnership with the tax man!”

Why do you think people who earn over $180,000 love negative gearing with residential property? It’s because every dollar they lose, the tax man pays nearly half of that loss in tax savings.

But where does that leave you if your taxable income is less than $180,000? Well, it depends on what your taxable income is.

If your taxable income is between $45,001 and $120,000, every dollar spent on tax-deductible costs will earn you a tax saving of 37 cents excluding the Medicare levy.

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Should you rush out and start spending?

The higher your taxable income, the more the ATO will shelter the cost. But for those with lower taxable incomes, you should only ever spend what you need to regardless of what portion of that spend is tax deductible.

Your tax-paying entity or company will also have an impact on your tax saving.

For example, a company with turnover less than $50 million is taxed at 26 cents in the dollar (for FY2020-21), while a self-managed superannuation fund (SMSF) is generally taxed at 15 cents in the dollar assuming it is in accumulation phase.

So, a dollar spent on a tax-deductible expense in a company or SMSF will cost the company 74 cents after tax and the SMSF a significant 85 cents after tax.

Which begs the question why negative gearing into property in an SMSF is considered so attractive when you realise that, for every dollar lost after rental income, the tax man only pays 15 cents?

The SMSF funds every dollar lost to the tune of 85 cents. The investment had better be a good one, if it’s to recover the after-tax losses over the period of ownership and still provide the SMSF with a solid capital gain.

Don’t forget there are other tax concessions available that will impact your decision on whether you incur a cost or not.

Obtaining a tax deduction in June 2021 will mean that you will receive the tax credit for that cost in your 2021 income tax return, and you will receive the refund for the expense when you lodge your tax return.

That means spending up in July will mean that you will not receive the tax saving until you lodge your 2022 income tax return and that’s at least another 11 months away.

In short, timing is a consideration, but only if you really need that tax deduction.

Remember the two golden rules of tax deductions:

1. Tax deductions aren’t a refund. At best, if you earn more than $180,000, you will save 45 cents per dollar, and if you earn less than $180,000 then your tax deduction goes down significantly, too.
2. If you don’t need it, don’t buy it. The full amount is better off in your pocket than any tax deduction.

Always think about the need, the timing and the tax saving (based on the applicable marginal tax rate) when offloading those hard-earned dollars of yours.

The easiest thing you can do to help with this is to make sure you’re capturing and tracking all your small business financials in online accounting software as well as consulting closely with a certified tax agent.

The information provided here is of a general nature for Australia and should not be your only source of information. Please consult an experienced and registered tax agent as each small business’ circumstance will vary for end of financial year.

Please note: This article was originally written by Steven Miller and published in 2015. This latest version carries information correct for 2021 with the help of Debra Anderson.