KiwiSaver investors are not taking enough heed of new tax regime, writes Michael Lang.
One of the least understood aspects of KiwiSaver is the new tax code designed to go with it. After returns, the level of tax investors pay is the biggest determinant of how quickly investments grow.
Tax should be considered as important as returns, because investors cannot work out what their real return will be until they have estimated their tax.
Most investors find tax too confusing to unravel and pay far more tax than necessary. However, New Zealand's new investment tax regime can be explained simply.
All KiwiSaver providers are required to use Portfolio Investment Entities (PIE).
All investors fall into one of four PIE tax brackets, which from April 1, have been set at either 0 per cent, 12.5, 21 or 30 per cent, depending on an investor's income level.
The tax rules for each major asset class have also been changed.
Instead of having one tax rate for all investments, each type has its own.
The attractive-looking interest rate advertised by a bank or when buying a bond is not the rate received after tax. Investors in shares or New Zealand-listed property pay little or no tax.
This means investors need to consider the merits of the asset they are investing in, as well as the rate at which it is taxed.
If a bond, a New Zealand share and a global share each returns 8 per cent before tax, an investor on a 21 per cent PIE tax rate would receive 6.32 per cent from the bond investment, 8 per cent on the New Zealand share investment and 6.95 per cent on the global share.
An investor should focus on these returns.
New Zealand has always had higher-than-average interest rates, which has made bank deposits attractive.
Until the new tax regime was introduced, almost all managed funds were taxed at 33 per cent, even if investors were on lower personal tax rates.
But the new regime means investors who play it safe with a large allocation to cash and bank deposits end up paying more in tax.
Historically, there has been little incentive to weather the volatility of shares and listed property.
Before taking tax into account, over the past 20 years three-month term deposits have averaged 7.5 per cent a year.
Over the same period New Zealand shares have earned investors 7.2 per cent a year and New Zealand listed property 7 per cent.
But the new tax regime changes the numbers significantly.
After tax, returns from three-month term deposits would be only 5.9 per cent a year, whereas New Zealand shares and listed property have returned 7.2 and 7 per cent respectively.
Surveys show more than a third of KiwiSaver allocations are to conservative default allocations, which are predominantly invested in assets such as cash and bonds that attract the highest tax rates.
Many investors would benefit from reconsidering the asset mix to which they are exposed.
Over 20 years, the difference between average term deposit and equity market returns after tax for a 30 per cent PIE tax investor is almost a third more capital to enjoy in retirement.
Death maybe inevitable, but paying a high level of tax on your investments and being miserable in retirement is not.
How they work:
* What is a PIE?
A managed fund, a superannuation scheme or a group investment fund that invests contributions in different types of investments. PIEs benefit from specific tax rules that provide investors with benefits when compared to other investments.
* What did PIEs replace?
Previously, most managed funds were taxed as companies. This meant all investors effectively paid tax at the company tax rate. PIE investors now pay tax at rates approximating their individual tax rates.
* Who must use it?
Every KiwiSaver provider.
* Who can choose to use it?
Most fund managers have adopted the PIE tax rules for their unit trusts, superannuation schemes and group investment funds. Many banks also offer unit trusts that have adopted PIE tax rules. These are commonly referred to as "cash PIEs".
* What is the key benefit of a PIE?
Investors pay tax at rates approximating their individual tax rates, but with a cap of 30 per cent - good news for investors who ordinarily pay higher rate tax. For those on less than 30 per cent tax, investing in a PIE ensures that their investment income does not impact on their Working for Families tax credits and on certain income-tested benefits.
Source: Michael Lang
* Michael Lang is the chief investment officer at NZ Funds.
