The Hidden Tax Trap of Redraw Facilities (Why You Should Use an Offset Account)

If you live in Australia and have a home or investment loan, you're probably familiar with redraw facilities and offset accounts. They seem to do the same job, and with redraws often having lower fees, they can look like the smarter choice.

But did you know that parking your money in a redraw facility could be costing you thousands of dollars in tax every single year? This is a hidden trap that 95% of people don't know about—and a lot of bankers and brokers don't even realise it.

This guide will show you with two real-life examples how this common loan feature can go wrong and why an offset account is almost always the safer choice.

Disclaimer: This information is for educational purposes only and is not financial advice. Tax laws are complex. Please seek professional advice before making any financial decisions.

The Lure of the Redraw Facility: What Are the Benefits?

On the surface, redraw facilities are very appealing. They are a common feature on home and investment loans that allow you to make extra repayments and then access—or "redraw"—those funds later if you need them.

This provides flexibility and peace of mind. In terms of saving on interest, a redraw facility offers the exact same benefit as an offset account. When you park money in either, it effectively reduces the outstanding loan balance on which interest is calculated. This means you pay less total interest and get rid of your loan sooner.

What's more, some lenders charge additional fees or require a higher interest rate for loans with offset accounts, which only increases the appeal of a redraw facility. For most people, this is the whole story. But what happens after you withdraw money from a redraw facility is where the trap is sprung.

The Redraw Trap: How a "New Borrowing" Can Cost You Thousands

Here is the critical distinction that most people miss, which is outlined in the ATO's Taxation Ruling TR 2000/2:

• Offset Account: Money inside an offset account is still your money, just like cash in a normal bank account.
• Redraw Facility: When you deposit money into a redraw facility, you are considered to be repaying the loan. When you withdraw money from the redraw, you are considered to be taking out a new borrowing.

Whether you can claim the interest on this "new borrowing" as a tax deduction depends entirely on how you use the money.

• If you use it for an income-producing purpose, like buying an investment property, then yes, the interest is tax-deductible.
• If you use it for personal use—such as buying a car, going on a holiday, or even putting a deposit on a new family home—then you cannot claim a tax deduction on the interest for that new borrowing.

Let's see how this plays out in two common scenarios.

Case Study 1: Turning Your Home into an Investment Property

John owns his home and has a $500,000 loan with a redraw facility. He inherits $300,000 and uses it to pay down his loan, reducing the balance to $200,000.

A few years later, John gets married, and with a baby on the way, the young family decides to upgrade. He withdraws the $300,000 from his redraw facility to use as a deposit on their new family home. Their original home is then turned into an investment property with the loan balance back at $500,000.

The Shocker: At tax time, John's accountant tells him that even though the loan is secured against an investment property, he can only claim a tax deduction on the interest for $200,000 of the loan. The other $300,000 was a new borrowing used for a personal purpose (buying a new family home), so the interest on that portion is not tax-deductible.

At an interest rate of 6.5%, John missed out on a tax deduction of $19,500 for the year. With his marginal tax rate at 47%, he found himself paying an extra $9,165 in tax. If he had used an offset account, none of this would have happened.

Case Study 2: Parking Savings in Your Investment Loan

Emily has an investment property with a $100,000 loan. She saves up $50,000 for a new car and decides to park it in her investment loan's redraw facility to save on interest while she looks for the right car.

A few months later, she finds her dream car and withdraws the $50,000. Her loan balance returns to $100,000.

Surprise, surprise: Emily's accountant also has bad news. She can now only claim interest on $50,000 of her investment loan. Because the other $50,000 was withdrawn for personal use, that portion of the loan permanently lost its investment character. The moment she used it to buy a car, she lost the ability to claim the interest as a tax deduction.

The Golden Rule: When to Use a Redraw vs. an Offset

Unless you are 100% sure that you will never withdraw money from a redraw facility for personal use, you should seriously consider having at least one offset account.

The small amount you might save in account fees is nothing compared to the thousands of dollars in tax deductions you could lose. Relying on a redraw facility is especially risky if you ever plan to convert your principal residence into an investment property or want to maintain the full tax deductibility of your investment loan.