Scaling the ladder to wealth gets harder by the day. Australia's punitive tax rates mean that you can lose almost half the earnings on investments in tax once you earn just $60,000 a year. On top of this, the growing trend to litigation means that more people are in danger of being sued for everything they have.

You can do little to reduce the tax on your earnings from your salary but there are strategies that will help you cut tax on your investments and, as a result, lets your portfolio grow much faster.

Better still, these vehicles often enable you to protect your estate from creditors, too.

But every investment decision carries advantages and disadvantages so it is vital to take expert advice before choosing the best route for you.

It can be extremely costly to change horses after the deed is done.

Individual Names

The simplest way to hold assets is in individual names but the problem is that any income you receive is added to the income you earn from your salary and may push you into a higher tax bracket.

For example, if you earned $58,000 a year and the income from your investments was $10,000 a year, you would pay tax at 48.5 per cent (including Medicare levy) on the bulk of your investment income. Also, if you worked overtime you would be losing almost half of the extra money you earned because income from the investments had nudged you into the top tax bracket.

But it is not just individual high-income earners who can be adversely affected by investment earnings.

Many tax concessions and government benefits are subject to an income test and, even though a low income-earning spouse may be in the 17 per cent tax bracket, the loss of the concession or the benefit can be punitive.

For example, once taxable income reaches $30,806 a year, the family tax benefit reduces by 30c for each dollar earned. Even though a person on this level of income is in the 31.5 per cent bracket, the loss of part of the benefit because of investment income means that the investment income is suffering an effective tax of 61.5 per cent.

Most home owners have experienced huge gains in the values of their properties and for many this will be tax-free as there is no capital gains tax (CGT) on profits made when you sell your own residence. But the CGT exemption is only available if the property is held in the personal name or names of the occupiers, which creates a dilemma for people who are trying to protect their assets from possible litigation.

They may be able to shelter their assets by having them held in the name of a family company or family trust but the price of this is loss of the CGT exemption.

One solution is to hold the family home in the name of the spouse who is least likely to be the recipient of a court action.

Due to the high divorce rate in Australia, this strategy does not sit well with some couples but legislation has been passed that gives force to prenuptial agreements, which, despite their name, can still be executed by married couples.

In summary, the main drawbacks to holding assets in individual names are that the money is available to the trustee in bankruptcy if you find yourself in financial strife, and you may pay unnecessarily high tax if you are high-income earner.

Family Companies

A company can be a highly effective vehicle for tax saving purposes as the company tax rate is a flat 30 per cent. Therefore, a company is more lightly taxed on its marginal income than an individual earning just $20,000 a year who pays tax at 31.5 per cent on any extra income above this amount.

However, companies do not have a tax-free threshold like individuals (nil till income hits $6000 a year) so the tax for a company with an income of $20,000 is $6000 while for an individual the tax on an income of $20,000 is just $2380 (17 per cent of $14,000).

For business people, a major benefit of operating through a company is that profits can be accumulated indefinitely in the 30 per cent tax rate. Then, when they retire, they can start to withdraw them as franked dividends, which are tax-free up to $60,000 a year for shareholders with no other income.

The major disadvantage of holding assets in a company name is that companies do not receive the 50 per cent CGT concession available to individuals who have held investment assets for more than a year.

But a company is the perfect vehicle for asset protection as shareholders are not personally liable for company debts unless they give personal guarantees.

Business and professional people who wish to protect assets while saving tax have to decide whether the loss of the CGT concession is worth the benefits only a company can offer.

Companies are also perfect vehicles for income splitting because a well-structured company may have various classes of shareholders and can determine what dividends are to be paid to each class at what time.

For instance, XYZ Pty Ltd might be owned by a family with three children aged 13, 15 and 19. If the parents had A and B class shares, and the children C, D and E class shares respectively, the directors could elect to distribute dividends only to the E class shareholder and pay no dividends on the C and D class shares until the children who owned those shares reached 18 and were no longer taxed at penalty rates (see below).

Family Trusts

A discretionary family trust is a separate entity just like a company. It can trade in its own right but it does not pay tax the way a company does.

Instead, the profits of the trust must be distributed each year to the beneficiaries of the trust who pay tax on these distributions at their normal rates.

The term "discretionary'' arises because the trustees have a discretion to decide how much income, if any, is paid to each beneficiary.

Beneficiaries who are under 18 pay "children's tax'' of up to 66 per cent on such income once it reaches $416 a year. But, once children reach 18 they are regarded as adults and pay tax at normal individual rates.

As well as providing some protection against claims from creditors, family trusts are also useful to reduce taxation by enabling income splitting.

For example, John Smith is a sole trader and earns $150,000 a year. The tax on this is $57,880. However, if his business could be run through a family trust the profits could be distributed as follows. The trust might pay a salary of $50,000 a year to John so he does not leave the 30 per cent tax bracket and his tax would be $11,380.

It could also make a tax-deductible superannuation contribution for him of $30,000. The contribution tax on this would be 15 per cent or $4500.

The trust could also distribute $50,000 to Mrs Smith and the remaining $20,000 could be distributed to the 19-year-old son who is at university and has no income. Tax on the son's distribution would be $2380.

The use of the family trust has enabled the family tax bill to be reduced from $57,880 to $29,640. This strategy has not just saved more than $28,000 in tax, it has also enabled the business owners to transfer $30,000 into superannuation where it cannot be touched if the business goes broke.

It is common to have a company as one of the beneficiaries of the family trust. This enables distributions to be passed down to the company and taxed at the company rate of 30 per cent.

Who Can Use a Company Or Trust?

Family companies and family trusts are used to run businesses they are not available for ordinary pay-as-you-go employees. There can be a fine line between who is eligible to operate a company or trust and those who are not, so expert accounting advice should always be sought before a company or a trust is set up.

However, as an example, think about a mythical business called ACE Plumbing Pty Ltd. The business employs a staff of 40, who work at a head office and two branches, and has a large client base that includes builders as well as home owners. There is no doubt that it can work through a company or trust.

Contrast this with Harry who is a plumber employed by ACE Plumbing. He is clearly an employee and cannot split income by working through a company or trust.

A Way Out!

One way to get around the laws restricting the use of a family trust is to include a testamentary trust clause in your will.

A testamentary trust is similar to a discretionary trust but there are two major differences. The trust is created by the will when the testator dies, not by a separate trust deed, and there is no $416 restriction on distributions to children. Distributions to them are taxed at normal adult rates, which means the first $6000 is tax-free, the next $14,000 is taxed at 17 per cent and so on up the tax scales.

Now let's see how it works in practice by thinking about a fictional couple who are almost 80, have four children in their 50s and several grandchildren in their teens. They have substantial assets that include four investment properties and a large portfolio of debentures, shares and unit trusts.

Naturally they wish to leave these assets to their children, and expect they would be eventually bequeathed to the grandchildren. Their will is drawn to reflect this.

When they die their wishes are carried out, but the additional assets cause problems for the children. They are all earning good incomes, so the extra income from the legacy is taxed at the highest rates.

If the will had bequeathed the assets to a trust, with the children as trustees, the children would still have controlled the assets but now they have the ability to "stream'' the income to the grandchildren.

This is because the assets would be held in the name of the trust, with the trustees (the children) having complete discretion over where the income is distributed. Instead of the children receiving the income, and losing almost half of it in tax, they could pay each grandchild $6000 a year tax-free.

There is no restriction on what the grandchildren do with the money, but it could be used for such expenses as school fees and uniforms. In other words, the first $6000 of these non-tax-deductible items could be paid from pre-tax dollars, not after-tax dollars.

There are other benefits, too. The assets are held by the trust, not by the children, so the trust assets are safe from creditors if the children get into financial strife.

Furthermore, when the children die, there are no costs to transfer the assets to the grandchildren because the assets remain the property of the trust. Also, the children have the flexibility to pay the income to themselves when they stop working and the grandchildren start working. By then there may be great grandchildren to whom the trust income can be streamed.

In short, testamentary trusts are simple in operation, and highly effective in saving tax and protecting your assets. Just make sure you take advice from your solicitor, financial adviser and accountant before you change your will.

Insurance Bonds

Even though there are few avenues for PAYG earners to save tax on their income, they can still accumulate money in a lower-taxed area through insurance/friendly society bonds and superannuation.

These are tax-paid investments, with the profits being added to the balance instead of being paid to you. However, an insurance bond fund pays tax at 30 per cent on the investor's behalf whereas superannuation funds pays tax at 15 per cent on the member's behalf.

Provided the tax rate paid by the fund is lower than your own marginal rate, investing through insurance bonds or superannuation can save tax.

Of course, there is no such thing as a free lunch. Super is inaccessible until you retire after age 55 and there may be exit tax if you make lump-sum withdrawals.

In contrast to superannuation, you don't lose access to your money if you invest in insurance bonds but if you redeem your money before 10 years are up there will be some tax on the profit.

However, if you can leave them untouched for 10 years all the proceeds are tax-free. There is no income added to your taxable income along the way and no CGT when you cash them in.

Superannuation

The major benefit of superannuation is that money is transferred to an environment where tax on earnings is just 15 per cent and CGT 10 per cent, and at retirement the money can be rolled into an allocated pension fund, free of any exit tax, where it can be used to start an allocated pension that may well be tax-free.

Money here is also protected from creditors but the lack of access can be a significant disadvantage.

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