Understanding Income Averaging
Income averaging is a tax-saving strategy introduced by the Australian Tax Office (ATO) to promote tax fairness. It is aimed at individuals who experience significant fluctuations in their earnings, and involves spreading out their taxable income over several years to find the average (i.e. the new taxable income in which they are assessed against).
This group of taxpayers would usually incur significant tax bills during their peak income periods, and lower tax bills during their quieter periods. However, by assessing their current-year income against their previous four years’ earnings, they can stabilise and lower their tax burden.
Put simply, by income averaging you’ll pay less tax during the years when your income significantly exceeds the average. In years when your income falls below or aligns with your average, your income will be subject to the standard marginal tax rates. The result being… less tax paid over the course of the five-year income averaging period than you would otherwise have paid without income averaging.
Who Can Use the Income Averaging Strategy?
Income averaging is not for everyone. It is specifically designed for a certain group of professionals, which the ATO refers to as “special professionals”. One thing special professionals have in common, due to the nature of their work, is fluctuating income patterns. Their earnings could spike in one year and drop in the next.
Special professionals who can benefit from income averaging include:
- Authors or Inventors
- Performing Artists
- Production Associates
Benefits of income averaging
The key benefit income averaging provides those who are eligible is a reduction in tax. This can be particularly advantageous for emerging special professionals, as it involves averaging their special professional income over a span of five years. This not only helps in managing taxes better but also provides some level of financial stability and predictability which is often not there due to the volatile nature of their income. They can plan their expenses and investments better without the fear of high tax charges in a good earning year.
When to Start
You become eligible to start income averaging once your earnings from your special professional work exceeds $2,500.
Keep in mind that income averaging exclusively factors in income generated from special professional work to compute your average. Any other sources of income, such as earnings from a second employment source not categorised as “special professional” work, interest, or investments, are not factored into this calculation.
As the income averaging system operates on an opt-in basis, whether you participate or not is something you can decide upon in consultation with your accountant. If you’ve determined that income averaging is right for you and you’d like to move forward with it, you can then decide if you’d like to enrol in the system starting from your next income tax return or, depending on your specific circumstances, if it’s beneficial to revise your prior income tax returns to claim the concession for a previous period.
How Long Does It Last
During the initial years of income averaging, many taxpayers experience significant advantages. This is due to their initial average for the years just before entering the system encompassing zero income. However, as your average income stabilises over time, the benefits can become less prominent.
You may be wondering if you can reap the benefits in your first year of income averaging and then opt out for the remaining years. It’s crucial to bear in mind that, since this system operates on an opt-in basis, you can’t opt out when your income stabilises. Once you opt into the income averaging system, you must remain within the system for the full duration of the income averaging period, i.e. five years.
Income averaging is a useful strategy for those with fluctuating income, allowing them to manage their tax obligations effectively. By spreading the income over multiple years, they can avoid heavy taxes in a particularly good year and make the tax burden more bearable. However, it’s important to note that this strategy isn’t applicable to everyone and is best suited for professionals like authors, artists, sportspersons, and inventors. If you’re a “special professional” and would like to discuss how income averaging could work for you, we encourage you to book a complimentary consultation with a Lemonade Beach Accountant.
Always consult with a tax professional before deciding on any tax strategies to ensure it’s the right fit for your situation.