What to do with more cash coming in the door
The planned stage 3 tax cuts offer the opportunity to take a fresh look at investing and life goals.
The stage 3 tax cuts will give high income earners a meaningful increase in take home pay. Any increase in cash flow offers investors the opportunity to thoughtfully assess the best way to improve their financial position and quality of life.
We provide an overview of the tax cuts, considerations for investors and hear from three members of the Morningstar team on what to do with an increase in cash flow.
What are the stage 3 tax cuts?
It is rare for government policy changes to have a clear, immediate and direct impact on an individual’s ability to consume and save. Many government policies aim to stimulate economic growth. Yet the connection between economic growth and investment returns is dubious.
The stage three tax cuts are a hotly debated policy item, and a policy rarity in that it has an immediate impact on individuals and their capacity to consume and save.
With stage 1 and 2 already completed, stage 3 focuses on high income earners. The cuts remove the 37% marginal tax rate and reduces the 32.5% marginal tax rate to 30%.
For reference, the current and upcoming tax rates are outlined below, and are set to come into effect 1 July 2024:
Current marginal tax rate:
Proposed marginal tax rates (from 1 July 2024):
In effect, this means that someone earnings $46,000 will pay the same tax rate as someone earning $200,000. It also means that high income earners will be receiving a significant bump to their take home earnings, with those currently in the highest marginal tax rate receiving the sweetest deal.
You can see where this tax cut runs into some controversy. Opponents of the tax cut argued that the removal of a tax bracket will further inequality in Australia. Proponents countered that many Australians have experienced ‘bracket creep’ – when wage growth results in lower income workers creeping into higher brackets. In some cases this is undoubtably true, but overall wages growth remains stagnant.
Maybe we can take a lesson from the UK. In 1696, they introduced a window tax in an effort to make the tax system more progressive. The tax outlined that you would pay a surcharge based on how many windows you had in your home. It was theorised that the poor would naturally have less windows and would pay lower taxes. Although this may have been true in rural areas, those in urban centres would be living in shared accommodation with way too much natural light for their tax bracket.
This of course led to creative forms of tax avoidance – boarding up windows and constructing houses that were practically unliveable with no natural light in some rooms. There is clearly a long history of trying to create fair tax policy.
Tax policy will always be a balancing act between scalable policy that serves the majority, gathers enough revenue and pleases enough constituents to stay engender support for the government. Whichever side you sit on in this debate, it seems as though the Albanese Labor government will continue with the cuts.
Restraining lifestyle creep
As investors we must focus on the real outcomes of policy and what it will mean for you. If you’re a high-income earner, this means more cash. To ensure we achieve our financial goals we need to resist the urge to resort to lifestyle creep after unexpected windfalls.
Lifestyle creep occurs when your expenditures grow with your income. This isn’t always bad – I spend more money than 20-year-old Shani. I also don’t live in a share house and eat cheese toasties most nights for dinner. Although I occasionally still indulge in my ‘student nachos’ – a horrifying meal of corn chips, salsa and melted cheese. I think we can all agree that a more sophisticated palate can be a worthwhile investment in improved quality of life.
We make money to live. And we all want to live comfortably. The difference is the intention. Intentional spending gives us control over the outcomes of our money. When we have extra cashflow, intentional actions can mean the difference between spending without improving your life and intentionally directing our resources towards the things we value the most.
The powerful combination of cash flows and time
Combine extra cashflow with time. It could mean a holiday sooner, paying off your mortgage earlier, or having enough of an emergency fund to provide peace of mind and prevent discomfort.
It may seem like this article is not for everyone and that we’ve aimed this at high income earners. Practically though, this advice goes for any investor that’s able to find a surplus in their budget and wants to put it to work.
It is important to acknowledge that for a lot of people everyday costs have skyrocketed. Inflation has impacted almost everything – from food, entertainment, leisure and travel. It costs more to do almost everything.
This has resulted in a lot of people cutting back and reducing spending. Sometimes this is a good thing. If you’ve experienced lifestyle creep, this can bring you back a couple of squares and allow the stage 3 tax cut to pump into your investments. For others, this has meant severely cutting back on their quality of life. For those people that benefited from stage 1 and 2 tax cuts spending reductions have been focused on the basic ‘needs’ of life.
Investing is not the end goal. Investing is a means to an end and you shouldn’t feel guilty about spending money that you’ve earned. Again – we come back to intention. Intentional spending, saving and investing is the key to ensuring the right balance. Understanding that forgoing cash today means that you may have more in the future. Understanding that sometimes you need that money today. Regardless – ensure there is intent behind your decisions.
I will be investing any extra cashflow I receive and following my approach of trying to get as much money into the market as possible to let compounding do the work. I also asked a range of investment professionals from Morningstar what they’d do with the cash across three income levels. Surprisingly, none of them suggested more windows.
(These amounts do not include the Medicare levy or surcharge)
Brian Han, Director of Equity Research
Don’t overthink it.
Put all of it in a global equities or an emerging markets index fund and forget about it – don’t even try to time the market. Just do it.
Then, let the resilience and ingenuity of the human race and market economy work their magic of compounding on your extra investments.
Chances are, in 10 or 20 years’ time, that money will amount to a great sum, without you having wasted a single minute or dollar being swayed by daily market noise emanating from fear and greed.
But if you DO want to overthink it, how about this?
Spend half of the money on time-tested books on investments, business-building, psychology, philosophy, and biographies of eminent (or exposes of dubious) historical characters in any field.
And every time you finish one of these books and think you’ve learnt a lesson or two from it, spend a small portion of the rest of the money on stuff you really enjoy as a reward.
By the time you finished all the books, you would be much wiser, having profited from the experiences of all those who went before you – and got to have some treats along the way as a bonus.
Whichever option you choose, the magic of compounding will benefit you greatly over the long term, whether in money or in wisdom.
Mathew Hodge, Director of Equity Research
The answer will depend. In practice just adding it to the mortgage is not a bad habit. Even if it’s just some portion of the benefit.
If disciplined, investing the difference is likely to be a better strategy longer-term so long as the returns are superior to the savings on interest from the mortgage. That’s not a high bar in terms of return expectations in the long run, but the challenge there is staying the course. So it becomes about discipline and psychology rather than any special investor insight. And if it’s possible to set up an automated deposit to a selected fund, ETF or other investment, then that would seem an appropriate approach.
Mark LaMonica, Director of Product Management, Individual Investor
A tax cut of this magnitude is effectively the equivalent of a raise so I will be following the process I have gone through with each raise I’ve received in my career.
I have always tried to be deliberate and structured with the way I’ve handled raises. When I was younger it occurred to me that a raise was both an opportunity but also a risk to my financial wellbeing. I saw many people simply let lifestyle creep take over as their salaries increased. There are always more ways to spend more money and ultimately after an initial period of pleasure that comes from increasing our spending it quickly becomes a new bare minimum or floor to our lifestyle and we devise new things to spend money on if only our salary would increase. Spending more also has other financial implications because it means that we should increase our emergency fund savings to match the increase in expenses and it becomes harder to save for retirement as we need a larger portfolio to support a more expensive lifestyle.
As I got each raise and with this upcoming tax cut I take the time to reassess my goals. Am I saving enough towards my goals and could increased saving bring down the required rate of return needed to achieve my goals? A lower required rate of return increases the likelihood that a goal is achieved. In my current situation I have two main goals that I’m trying to save towards.
The first is retirement and in this case I am comfortable that I am on track to achieve my goal and that my required rate of return is reasonable and does not need to be brought down further by increased savings.
My next goal is to use investment accounts to fund travel through income generated from my holdings. My plan is to have a new account switch to paying out income to pay for travel every five years. In this case my next account which will raise my travel income by ~50% will kick in during 2024 when I turn 45. I do not believe that increasing my savings into this account is needed given the scale of the increase in income that is due to kick in at my 45th birthday. I am also comfortable that I’m on track with the account I plan to start spending at 50 and don’t believe that additional savings are needed.
Overall the biggest risk to my financial position is a large scale rent increase. As a renter and given current rental conditions I believe that it is likely my rent will meaningfully increase when my lease expires in March of 2024. My plan is to save three quarters of the tax cut into my emergency fund which effectively “banks” the money which can then be redirected towards the rent increase that I’m expecting next year. That way I can ensure my lifestyle will not have to change given increases in what I pay for housing.
While my emergency fund is adequate right now it never hurts to have more money in there. That will help with another risk to my financial position which is losing my job. As somebody who is only moderately competent at my job there is always a risk that I will lose it and given my age it is likely going to be a longer process to find a new job so I think a larger emergency fund will be the best use of the money.
Graham Hand, Editor-at-Large, Firstlinks
A question to anybody on “Where would you put the extra funds and why?” requires a personal context. We are all different. I am 65-years-old, I have worked in senior roles in financial markets for 45 years, I have placed the maximum allowed into superannuation each year, I have not had a mortgage since the 1980s and the kids left home long ago (but we still have a dog). You don’t need a compound interest calculator to realise I am more focused on the new tax on superannuation balances over $3 million than the stage 3 tax cuts.
So while I appreciate the sentiment of eliminating bracket creep in the personal tax system, the Government could better target ways to spend the money. There is a strong case to modify the changes before they come into effect, leaving the larger tax breaks for lower income levels.
Where am I placing my marginal investment dollars? My portfolio includes growth assets in Australian equities, global equities, infrastructure, property and alternatives. But I have increased my allocation to cash and floating rate bonds in the last year or two to protect capital in the face of considerable uncertainty.
Rising interest rates means an investment such as a hybrid with a major Australian bank is paying a floating rate currently around 7%, which is more than I expect from equities this year. My caution relates to the impact of higher rates on consumers and companies, earnings declines in a US recession, war and geopolitical conflict and sustained inflation So given my defensive attitude, lower taxes will lead to more invested in cash or bonds for the rest of 2023 and well into 2024, as central banks and markets struggle to resolve the excess liquidity of recent years.