With SMSF investors looking for new ways to boost returns and earn more income, gearing has become increasingly popular. Especially with contribution caps limiting the ability of members to top up their investments without a tax penalty.
But while borrowing to invest can multiply your gains if you invest successfully, traditional gearing techniques also run the risk of significant losses if the market falls. Which is why strategies like margin lending are not available to super funds.
But there is a way you can put the power of gearing to work within your SMSF, while still protecting yourself against falling share prices.
Gearing with protection
A protected loan is an interest-only loan that you can use to invest in shares through your SMSF for a term of up to five years. You can borrow between 50% and 100% of the cost of the shares, so you can build a bigger portfolio faster. But your loan is also capital protected, so if any of your shares has fallen in value at the end of your loan term, you can simply hand them back to the lender and walk away. Meanwhile, you keep the profit from any shares that have risen in value.
Of course, that protection comes at a cost — in this case, a one-off protection premium paid at the beginning of your loan. But not only can you offset that premium against any capital gains from your portfolio, you can also claim the interest costs as a deduction, up to the variable RBA deductible rate (currently 8.80%). This means that your loan could be cash-flow positive over the term.
Example
Sue and David are trustees for their family SMSF. Sue and David intend to use a protected loan to borrow half of the cost of a $100,000 investment in the SPDR S&P/ASX 200 Fund (ASX code: STW). Here are the details:
| Sue and David's contribution | $50,000.00 |
|---|---|
| Loan amount | $50,000.00 |
| Total investment | $100,000.00 |
| Gearing ratio (LVR) | 50.00% |
| Protection premium (paid in advance) | $4,600.00 |
| Tax rate of SMSF | 15.00% |
| Investment term | 5 years |
| Variable interest rate | 7.59% pa |
| Estimated deductible rate | 8.80% pa |
How will Sue and David's strategy affect their SMSF's returns?
While their SMSF will need to pay a total estimated interest of around $19,000 over the life of their loan, that interest cost is more than offset by the $35,000* in dividends and franking credits their SMSF receives from their investment. So their strategy generates an immediate income for the fund.
Sue and David are also able to claim their interest costs as a deduction for the fund, creating an even better result after tax. And by investing in July, they get the benefit of a full year's deductions when they submit their tax return next year.
At the same time, they've doubled the potential capital gain if their investment rises in value over the five year term. In fact, their portfolio only has to achieve a gain of less than 1% a year to earn back their $4,600 protection premium.
Meanwhile, they have the peace of mind of knowing that their loan is protected at maturity if the share market falls.
Strategy benefits
Create the potential for more capital growth, dividends and franking credits by building a larger portfolio.
Invest in the share market with loan protection at maturity.
Get the benefits of gearing without margin calls.
Invest tax-effectively
Tailor a strategy to suit your SMSF.
* Source: IRESS. Their accuracy cannot be guaranteed and future outcomes may vary markedly. The case study is hypothetical and assumes that franking credits and dividend rebates are fully available to investors.
