Why Tax Rates Can Be Misleading

“In this world nothing can be said to be certain, except death and taxes.”
— Benjamin Franklin

No one enjoys paying tax — especially on the returns from their hard-earned savings. But when it comes to investments, the headline tax rate can often give a misleading impression of how much tax you actually pay. Let’s look at why that is, focusing on how tax works for Portfolio Investment Entities (PIEs).

Understanding PIR Tax Rates

PIE funds use what’s known as a Prescribed Investor Rate (PIR). Your PIR is based on your taxable income from the last two tax years. The current PIR bands are:

* Based on the lower income of the previous two tax years.

At first glance, an investor with a 28% PIR might assume they’re paying 28 cents in tax on every dollar of investment earnings. In reality, the effective tax rate — what’s actually paid as a percentage of returns — is often much lower. That’s because the tax treatment differs depending on what the PIE invests in.

How Different Investments Are Taxed

Different asset types inside a PIE are taxed in very different ways. For example:

• Cash and Fixed Interest — Tax applies to the total return (interest plus any capital gains).
• Australasian Equities — Generally, only dividends are taxed. In New Zealand, dividends are paid from a company’s after-tax income and investors receive a tax (imputation) credit.  Capital gains are not generally taxed when Australasian Equities are managed in a PIE, which is one of the key advantages of PIE investing. However, note that New Zealand investors who actively trade a portfolio of direct shares to make a profit could be classified as ‘traders’ by IRD and potentially be subject to tax on capital gains.
• International Equities — These are taxed under the Foreign Investment Fund (FIF) rules. FIF investments within a PIE structure are taxed on a deemed return of 5% of the investment’s value each year, regardless of the actual return. There are additional options for determining tax on FIF investments when they are held outside of a PIE though the headline tax rate may be higher potentially, up to 39%.

So, while defensive assets like cash and bonds are fully taxed on their returns, growth assets such as shares are only partially taxed. This mix has a big impact on how much tax an investor truly pays.

Headline vs Effective Tax Rates

To illustrate the difference, we modelled the effective tax rates for Saturn’s core investment strategies — based on our long-term return expectations, asset allocations, and assuming a 28% PIR.

As the table shows, the effective tax rate is consistently lower than the headline rate. Strategies with higher allocations to growth assets — such as shares — tend to have a lower proportion of total returns lost to tax.

Factoring in Advice Fees

An often-overlooked factor is that financial advice fees are generally deductible against taxable income. While the exact impact depends on each investor’s circumstances, the deduction of advice fees effectively lowers the true after-tax cost of investing, improving net returns over time.

The Bottom Line

For investors, it’s important to look beyond the headline PIR rate. Your effective tax rate depends on your investment mix — and the more exposure you have to growth assets, the more tax-efficient your overall returns may be.

Need some advice on your investments? Reach out to one of Saturn’s experienced and impartial financial advisers.