Should you salary sacrifice or pay down your mortgage?

This is a common question that we hear from clients…. “Should I be using my spare cash to make extra mortgage payments, or should I look to get the tax benefits from salary sacrificing?” Unfortunately there isn’t a clear answer, as it depends on your financial circumstances… but let me explain further.

Salary sacrifice

Briefly, salary sacrificing is when instead of receiving part of your salary in cash you invest it into your super fund. This can reduce the tax you pay on the salary you contribute whilst, at the same time, your super is accumulating further funds in preparation for your retirement.

So the main benefit of salary sacrificing is the tax deduction that you receive. You need to pay 15% superannuation contribution tax on the salary sacrificed amount, so if your marginal tax rate is above 15% there should be a benefit for you.

Pay down mortgage

For the vast majority of people, their mortgage is not tax deductible and this means that you are paying the interest from your after tax or ‘net’ salary. To get an idea of the true cost to you, you therefore need to take into account the tax you pay. So let’s say you earn $10,000 per month and you want to use one month’s salary to reduce your loan. You don’t reduce your loan balance by $10,000, as you need to pay tax on this income. You will actually only reduce the loan by $6,150 (based on a marginal tax rate of 38.5%).

Which is better?

This is going to depend on your marginal tax rate, the current interest rate of your mortgage and the investment return you can get on the funds invested in your superannuation fund.

For example: using the figures above for someone earning $10,000 per month, salary sacrificing $10,000 is going to have $8,500 invested in superannuation (after 15% superannuation tax). At the end of the year these funds will have grown ideally to $9,000 or $9,500 if we assume an investment return of 5.9% – 11.8%. So from our gross monthly income of $10,000 at the end of the year we hope to have somewhere between $9,000 and $9,500 based on our investment return assumptions.

With the same situation if we decide to reduce our debt, we will reduce the loan by $6,150 after paying income tax. This will save us the interest on the loan of say 6%, which is a saving of $369. So our total benefit is $6,519, which is a lot lower than the salary sacrifice benefit of $9,000 – $9,500.

Summary

In this case, on a pure numbers basis it is better for the person to salary sacrifice. In reality we should consider other points as well such as:

Your age. The younger you are the further away you are from getting access to your superannuation, so there is some benefit in reducing your mortgage and your risk, even if it doesn’t give you as good a result ‘financially’.

Your debt levels. If you have a high debt level compared to your assets you may be better off reducing your debts with some or all of your spare cash.

Your financial goals. For some people being debt free is very important, but for other people they look at their net wealth after taking into account all assets and debts.

Without going into too complex of an analysis, if your marginal tax rate is 30% or above you will normally be better off on a numbers basis by salary sacrificing. If your marginal tax rate is below 30%, the best option will depend more greatly on interest rates and investment returns.

This article should be considered general advice and is not intended to relate to your personal situation. If you would like specific advice about your personal situation, please call our office on 03 9077 0277 to organise an initial meeting to discuss your financial goals and how we can help you achieve these.