Q – I've noticed that the software is giving my client a 'tax credit'. Could you explain why and how the tax credit comes about?
A – The short answer is that what the software displays as a tax credit is effectively a tax refund resulting from an overpayment of income tax during the previous financial year.
In each year of the plan, the software performs tax calculations in two stages:
- During the financial year – PAYG (Pay As You Go) withholding is estimated and applied based on employment and other taxable income, similar to tax withheld by an employer.
- At the end of the financial year – a final income tax calculation is performed based on total taxable income, deductions, and concessional superannuation contributions.
If the PAYG tax withheld during the year exceeds the individual's final tax liability after all eligible deductions and adjustments are taken into account, the difference is modeled as a tax refund (shown as a tax credit) in the following financial year. This reflects the annual tax reconciliation completed when an Australian tax return is lodged.
In the example demonstrated above, income tax is calculated based on the individual's taxable income, and PAYG (Pay As You Go) withholding is deducted from employment income throughout the financial year.
Now, let's assume the individual is also making concessional superannuation contributions (such as salary sacrifice) and is eligible to claim any applicable tax deductions:
Concessional superannuation contributions can reduce taxable income, which may lower the individual's final income tax liability. By reducing taxable income, a smaller portion of earnings may be taxed at higher marginal tax rates, potentially resulting in a tax refund when the annual tax return is assessed.
The reduction in their total taxable income, of course, results in a reduction of tax to be paid at the individual's marginal tax rate. The result is that, when the software carries-out its end-of-year tax calculation, it recognizes that the individual has overpaid tax in the current year and is entitled to a refund that will be credited in the following year of the plan, as illustrated below.
Several factors can contribute to this overpayment, including:
- Concessional superannuation contributions (salary sacrifice or employer contributions), which can reduce taxable income
- Investment-related deductions, such as deductible interest expenses or investment property expenses
- Work-related expenses and other eligible tax deductions
Because these adjustments reduce the final tax liability, they can create a situation where the tax paid throughout the financial year exceeds the amount actually owed. This results in a tax refund, which is reflected in the following financial year.
Think of this as an annual reconciliation of income tax, with refunds and liabilities modeled one financial year in arrears.