High-Interest Savings and Unexpected Tax
Higher interest rates have been a welcome change for many savers. Since the RBA began increasing the cash rate in May 2022, money in the bank has benefited from better returns.
However, with the increase in interest income comes an increase in tax, and this can come as an unwelcome surprise.
The Effect of Higher Interest Rates
The rise in interest rates has had a direct impact on savings accounts.
For example, first home buyers saving for a deposit and retirees keeping a cash buffer in the bank have all seen their interest income grow. However, unlike salary income, tax is not automatically withheld from interest earned on savings, meaning it can easily be overlooked throughout the year. This can result in a larger-than-expected tax liability when tax time arrives.
> The average tax refund for the 2024 financial year, as of 31 October, was $2,680, down from $2,842 in the previous year.
This decrease can be attributed to several factors, including the end of the low- and middle-income tax offset in June 2022 and the reduction of work-from-home tax deductions.
However, one of the largest contributing factors has been the increase in interest income from high-interest savings
Higher Interest mean more tax
Let us consider a typical example: If you have $50,000 in a high-interest savings account that is earning 5% interest, this will result in $2,500 of income over the course of the year. If you are on the highest marginal tax rate of 39% (including the Medicare levy), the tax on this interest will amount to $1,000. This is a significant increase compared to the $200 tax that would have been payable on $500 of interest income if the interest rate had been 1%.
In short, the higher the interest rate, the more tax you are likely to pay, especially if you are in a higher tax bracket.
How to Manage the Increased Tax Burden
Fortunately, there are several strategies you can implement to minimise the impact of this higher tax liability, particularly if you have substantial savings or if you are saving for a specific goal, such as purchasing a home.
1. Transfer Savings to a Lower-Income Partner or Child
One effective strategy is to transfer some of your savings to a spouse or child who is on a lower income. This works because the tax you pay on interest depends on your marginal tax rate, so if you can reduce your overall taxable income by shifting savings to a family member with a lower income, you could lower your tax bill. For example, if you are earning $200,000 per year and your partner is earning $80,000, keeping your savings in your account means you will be taxed at the highest rate of 45 per cent, while your partner would be taxed at a lower rate if the savings were in their account.
It is also common for parents to transfer savings to adult children who are paying off a mortgage. If the parents do not need immediate access to the funds, the interest savings could reduce the mortgage interest burden more effectively than the parents would have gained by keeping the money in their own high-interest savings account.
However, it is important to be mindful of potential relationship issues in the future, particularly if the money is held in the name of a spouse or child. In some cases, a family trust may be a more suitable option, as it allows income to be distributed to family members in a tax-efficient way.
2. Consider Super Contributions
Contributing to superannuation is another strategy to reduce tax on savings. The First Home Super Saver Scheme allows you to save for your first home through superannuation, which comes with significant tax benefits. Contributions to super are taxed at a concessional rate of just 15 per cent, and any earnings within the superannuation fund are also taxed at a lower rate than personal income tax.
For instance, if you direct a portion of your weekly income into super, the contribution will be taxed at 15 per cent, compared to your marginal tax rate, which could be as high as 39 per cent. Over time, this can significantly reduce the tax you pay on your savings while allowing your deposit to grow faster than it would in a regular high-interest savings account.
If you are a first home buyer, the First Home Super Saver Scheme offers an even more compelling reason to consider superannuation as a vehicle for savings. By taking advantage of tax deductions on contributions to super, you can both reduce your taxable income and grow your deposit in a tax-efficient manner.
3. Invest Outside of Super
If you have already maximised your contributions to superannuation, you might consider investing outside of super. While this means you will not benefit from the concessional tax rates that apply to superannuation, it may be possible to defer tax by investing in assets like shares, which are subject to capital gains tax only when they are sold. If you hold these investments for longer than 12 months, you can benefit from the capital gains tax discount, which reduces the amount of tax payable on the profit.
4. Prepay Interest on Loans
If you expect to earn significantly more in one year than in the next, you could consider prepaying interest on loans. This would allow you to bring forward a tax deduction, reducing your taxable income for the current year and therefore reducing your tax liability. However, this strategy is not always effective and may not be suitable for everyone, as it depends on your individual financial situation.
Planning
The key is to manage your savings effectively by using tax-efficient strategies to minimise your tax burden. With the right planning, you can ensure that more of your hard-earned money stays in your pocket, while also building your wealth for the future.
If you are unsure of which strategy is best for your situation, consulting with a financial adviser could help you make informed decisions about how to manage your savings and reduce your tax liability.
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