In last weeks post, we set about uncovering what a retirement plan is, and how to develop one in preparation for your future.

This week, we will be discussing the steps to get to retirement and the best way to develop a structure.

The steps to get there and developing a structure:

One of the keys to wealth accumulation is structure. Apart from the asset protection benefits of using the correct structure, you need to understand the impact taxation will have on your returns, which has a significant effect on the long term value of your assets.

Consider this scenario . . .

At the beginning of each year, for 15 years, you invested $10,000 in an asset that provided average capital growth of 5% and an income return of 4%. The differences in the value of this asset in 10 years time will be different depending on the tax rate applied to the income earned.

This table shows the impact of tax on earnings on the same capital investment over a 10 year period. Tax is just another cost, however quite a significant one. The larger the amount of capital invested, the greater the dollar amount of tax paid on earnings.

Tax rate on income Capital value in 10 years
0% $165,603
15% $160,049
30% $154,690
46.5% $149,012

* assuming the after tax income is reinvested in the same asset

What if the capital invested each year was $50,000?

Tax rate on income Capital value in 10 years*
0% $828,015
15% $800,244
30% $773,449
46.5% $745,060

* assuming the after tax income is reinvested in the same asset

You can see that the larger the capital, the greater the dollar impact that tax has on the final capital value.

Let’s take this a step further…

The examples above are based on the same amount of capital being invested each year. But where does this capital come from?  It has to come from the income or profits that we make. If you were taxed at the highest marginal tax rate of 46.5% on your income or profits, you would have a lower amount of capital to invest compared to the same income being taxed at 30% or 15%. At a tax rate of 46.5%, the income or profit that is required to provide $10,000 or $50,000 capital to invest is $18,692 and $93,458 respectively. If these profits were taxed at either 30% or 15%, instead of 46.5%, the impact on the capital value, using the same return assumptions as above, would be:

Capital value in 10 years*
Tax rate on income $18,692 $93,458
15% $254,286 $1,271,412
30% $202,396 $1,011,996
46.5% $149,012 $745,060

* assuming the after tax income is reinvested in the same asset

You can see by these numbers the massive impact that the tax rate, applied to income earned, can have on your capital accumulation strategy.

The key to managing the amount of tax you pay is managing the activities that different entities undertake. Care and attention needs to be taken when establishing entities or restructuring assets, with a clear understanding of tax law. The incorrect approach could create significant, unplanned tax liabilities.

Continuing on from this, next week we will be discussing some general points on tax, and how they can apply to different types of entities.