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Understanding tax and debt is freedom

The Broke Millennials Club
·10-min read
Here's how to take control of your tax, and your debts. (Source: Getty)
Here's how to take control of your tax, and your debts. (Source: Getty)

The truth is, no matter how much investing or saving you do, you’ll never really be ‘rich’ until you understand tax and debt and how they work.

Those two words might keep you up at night, but have you ever thought about using debt and taking advantage of taxes to increase your cash flow?

As Robert Kiyosaki, author of Rich Dad, Poor Dad says, “When it comes to taxes, start thinking like the rich...Lots of people will tell you how to get out of debt, but you need to know how to use debt instead”.

Most Australians, even those who are highly-educated, lack the basic financial knowledge about how you can actually use debt to make money and how to lower your tax obligations both legally and ethically, meaning more money in your pocket.

Unlike we’re all led to believe, sitting on your money, saving it away for the future and waiting is not how you’ll make your millions.

So how do you do it?

You use your debt as a leverage to multiply your returns (this might sound tricky but it doesn’t need to be).

Wait, so you’re saying I can use my debt and taxes to actually make money?

Yep, that’s right.

And it's as simple as 1, 2, 3 (actions, that is).

A little bit of time spent learning about this can reap big rewards.

To help you on your way, here are some things you might want to consider if you want to increase your wealth using debt.

The difference between ‘good’ and ‘bad’ debt

Bad debt generally means all the debt you have which was used for things which depreciate in value, don’t produce any income and aren’t tax deductible. For example, using a personal loan or credit card to buy something like a new car or a holiday is a type of ‘bad’ debt. It is more likely to reduce your wealth because of the interest and fees.

Good debt is debt you have from buying assets which are likely to grow in value and/or produce an income for you. Such as stocks, investments or even a student loan. It’s this type of det which you can use to create wealth.

How to turn your ‘bad’ debt to ‘good’ debt

Now you know the difference between ‘good’ and ‘bad’ debt, you’ll probably want to get rid of all your ‘bad’ debt fast. Here are a few steps you can take to get your personal finances in a better position to start using good debt to create wealth.

1. Consolidate your debt

Do you know how much all your debt is costing you? And we’re not talking about just the balance, but the fees and interest associated with the debt.

Having multiple debts and paying them all off separately usually isn’t the best way to manage it. Instead you could look to move all your debt into one combined debt so you’re paying off only one balance every month - and one balance means one set of fees and interest rates.

You could even think about increasing your mortgage slightly and using the funds to pay off other ‘bad’ debt like credit cards and personal loans. Your home loan repayments would be largely unchanged but you’ll be using its lower interest to pay off the higher-interest debt.

2. Make your savings work harder

You can keep your money in a cash savings bank account as an emergency fund, but you’d be much better off putting it into a high-interest saver or mortgage offset account where you can earn higher interest without locking away the funds.

3. Manage your cash-flow better

Managing cash flow is vital for determining the difference between ‘good’ and ‘bad’ debt. The idea is to increase the frequency of your interest payments, using the interest-free period on a credit card, paying your entire salary into an offset account or any other method which basically lets you free up your funds without paying interest.

How to use your debt to make you rich

Now you’ve minimised the amount of ‘bad debt’ you have, you might want to think about how to start creating some good debt. These 5 steps will help get you started;

1. Borrow to create wealth

Borrowing or taking out a loan to invest (for example, in property or shares), which is also known as ‘gearing’, is a great way to build wealth over time.

If you use the money you’ve borrowed to invest wisely, you should be able to watch your investments grow in value over time, hopefully to the point that the money you’ve made off the investment even covers all the costs associated with taking on the debt in the first place (such as interest rates and fees).

An extra bonus is the interest charged on the debt you’ve taken out could also qualify to be tax deductible (because you can claim borrowing expenses on your tax return).

Ideally you want to be in the position that your new investment generates enough return (money back) to not only cover your initial debt but also give you extra money on top of that.

You’d be making money!

A great example of this is taking out a home loan to buy an investment property which you are then able to either rent out for enough money that it covers the cost of your debt, or you’re able to renovate and sell for a higher price (which again would cover your debt and even leave you with an additional sum).

2. Recycle your debt

‘Debt recycling’ is another very easy way to build your wealth over time.

Basically it is the concept of turning some of your debt into debt which will generate more money.

A great example of debt recycling is the same concept as borrowing against your mortgage (as mentioned above) to pay off debt. You could also borrow against your mortgage (otherwise referred to as redrawing against your equity) to free up money which you would then invest into other property, or even shares which then itself would earn you a passive income.

The process helps by converting useless debt into debt which can earn you an income that you could use to pay back the loan.

Any excess money made could also be put towards your mortgage meaning you’re able to pay off your debt even faster than otherwise would have been possible.

3. Take advantage of your superannuation

We covered this in our last challenge, but contributing more to your super fund is one of the easiest and most accessible tax-friendly investments.

So you’d actually save money by diverting a portion of your hard-earned cash into your super.

How?

Because these extra contributions - also known as salary sacrifice or concessional contributions - are taxed at a much lower rate than annual income tax (at only 15 per cent versus annual income tax which starts at 19 per cent).

This means that if, for example, if you earn $95,000 a year, you could save up to 24c in every dollar sacrificed.

So how much can you contribute?

Your employer is legally obliged to contribute 9.5 per cent of your salary into your super and you are able to contribute extra - up to $25,000 in concessional contributions (pre-tax) and $100,000 in non-concessional contributions (after tax).

So there are three benefits to salary sacrificing:

  1. Paying less tax

  2. Taking home more money (because you’re paying less tax - it could even move you down a tax bracket if you’re on the cusp which means even more saving)

  3. Meanwhile simultaneously boosting your retirement savings.

Great, right?

And the best bit? Anyone can do it.

Salary sacrificing is best suited to anyone whose marginal tax rate is over 15 per cent - for reference anyone who earns over $18,201 per year would pay 19 per cent tax so basically, if you pay any tax, you might benefit from this process.

It is also suited to people wanting to build their super balance quickly - for example, people who have been out of the workforce for extended periods, or people close to retirement.

4. Buy a negatively geared property

While buying an investment property which covers your debt and any fees might be the ultimate goal, another way for you to pay less tax, and effectively boost your income (because you’re paying less tax), is by buying a negatively geared property.

It might not seem like a good idea but here’s the thing.

People who own an investment property which isn’t covered by the rent received from leasing it out may be entitled to a tax deduction.

This would mean you’re able to pay less taxes on your other income, such as your salary.

So the idea is that while the investment might cost you money in the short-term, not only would you benefit from a tax break on your income, meaning you’ll bring home more money and pay less tax, you’ll also hopefully have a property which increases in value over time to the point it’ll end up being worth more than you paid for it.

The risk

The downside, as always, to all of these ways to use debt to make money is the risk factor.

There is always a risk that your investment decreases in value meaning you would owe more on the loan than the value of your investment.

So if you’re unable to cover the shortfall and default on your repayments, your lender could end up taking ownership of your investments.

THE CHALLENGE

If what we've discussed above sounds good, this week's challenge includes some additional things you may want to try.

Remember, you should always seek professional advice in relation to your personal financial circumstances before you commit to any financial strategy.

Length of time to complete: 40 minutes

Part 1: Educate yourself

There is a wealth of knowledge available on the internet which can help you do your research on everything you need to know about good and bad debt, and how to use debt and taxes to make money. But the following resources can help to point you in the right direction.

Step one: Listen to finance podcasts from Rask, She's On The Money and Equity Mates.

Step two: Bookmark, follow and read investment ‘how-to’ blogs from Rich Dad, Poor Dad and Switzer Daily.

Part 2: Research if or how you can consolidate your debt

Step one: Gather information about all your debts. Contact your provider(s) or review your paperwork to work out the following information.

  • How much do you owe on each debt?

  • What interest rate are you paying on each debt?

  • What are the monthly fees on each debt?

  • Are there any fees associated with paying off the debt early (break fees or costs)?

Step two: Work out how much you can afford to pay off your debt each month.

Step three: Work out if there is any way of consolidating your debts. Here are three options:

  • Can you transfer credit card or store card balances to a credit card with a low and competitive balance transfer rate?

  • Can you consolidate debt by using your existing home loan?

  • Can you consolidate your various debts into one personal loan?

The guidance and suggestions provided in Yahoo Finance's 6 Week Financial Bootcamp are of an informational nature only, and are not intended to constitute financial advice. You should make your own enquiries as to whether the 6 Week Financial Bootcamp is suitable for your own personal circumstances. Yahoo Finance does not guarantee any particular outcome arising out of your participation in the 6 Week Financial Bootcamp.

By Samantha Menzies, contributing editor at Yahoo Finance Australia.

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