Should you change your investment strategy because of the CGT changes?

The capital gains tax (CGT) reforms have sparked debate about whether investors should favour income-producing investments over those focused on growth, in an effort to reduce their tax bill.

But a lower tax bill doesn’t necessarily lead to a better investment outcome.

New modelling of the reforms suggests that while higher-growth investments could face larger tax liabilities under the new rules, they may still leave investors with greater after-tax wealth over the long term.

Understanding the changes

Under the current rules, Australian investors who hold an asset for more than 12 months may be eligible for a 50% discount on capital gains.

From July 1, 2027, that approach will be replaced with an indexed cost-base methodology, designed to account for inflation when calculating taxable gains¹. The proposal would also introduce a minimum tax rate of 30% on capital gains.

To understand how these changes could affect investors, here is a model of two hypothetical portfolios over a 20-year period.²

• A higher-income portfolio generating 6% annual income and 4% annual capital growth.

• A higher-growth portfolio generating 2% annual income and 8% annual capital growth.

Both portfolios were assumed to deliver the same total pre-tax return of 10% per year. The key difference is how those returns are generated. 

Different returns, different tax outcomes

The reforms produce very different tax outcomes for the two portfolios. Under the new rules, the higher-income portfolio is around $4,000 better off than under the current regime, while the higher-growth portfolio is about $29,000 worse off.

^{Note: The example is illustrative only and is based on the factors stated. It should not be taken to contain or provide an estimate, projection or guarantee of future investment returns or tax outcomes.} 

The difference largely comes down to the relationship between capital growth and inflation. Investments with relatively strong capital growth generally benefit more from today’s 50% CGT discount, while lower-growth investments may benefit more from an indexation approach. Keep in mind a portfolio with greater exposure to growth assets would generally be expected to experience greater fluctuations and a higher risk of loss than a lower-growth portfolio.

However, tax is only part of the story. Despite facing a larger CGT bill under the new rules, the higher-growth portfolio still finishes with more after-tax wealth after 20 years, accumulating approximately $205,700 compared with $184,400 for the higher-income portfolio.

This is because a greater proportion of the higher-growth portfolio’s return remains invested and compounds over time. This highlights an important distinction: the investment that generates the lowest tax bill may not be the one that leaves you with the most money after tax. In some cases, paying more tax may simply be a by-product of generating higher returns. 

What about different markets?

This distinction may also be relevant when comparing different markets. Australian shares have historically delivered a larger portion of returns through income, while international shares have tended to generate more of their returns through capital growth. Under the reforms, those differences could lead to different tax outcomes, but investors should remain focused on total after-tax returns rather than tax outcomes alone. 

The bottom line

The CGT reforms could change the relative tax treatment of income and capital growth. While this modelling suggests lower-growth portfolios may benefit from an indexed cost base and higher-growth portfolios could face larger CGT liabilities, tax is only one part of the equation.

The modelling shows that even after paying more CGT, a higher-growth portfolio can still generate greater after-tax wealth over the long term because more of its return remains invested and compounds over time. However a higher growth portfolio would also increase the exposure to market fluctuations and a higher risk of loss.

The right portfolio will depend on an investor’s goals, risk tolerance and circumstances. Tax outcomes are not guaranteed and will vary between investors. Rather than focusing solely on minimising tax, investors should focus on maximising long-term after-tax wealth.

^{1. Note that if you had acquired assets prior to 1 July 2027, part of your capital gain may be subject to the CGT discount if it was held for at least 12 months; however this discount gain is deferred until you sell your asset.}

^{2. The modelling assumes an Australian resident individual investor eligible for the CGT discount under the current rules and a $50,000 initial investment, a 20-year holding period, a marginal tax rate of 47%, annual inflation of 2.7%, reinvestment of after-tax income distributions reinvested annually, and payment of CGT at the end of the investment period. Investment fees, transactions costs and Medicare levy are not included.}

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Source: Vanguard
Reproduced with permission of Vanguard Investments Australia Ltd
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