A tax take on pension fund investing

If you no longer had to pay tax, would it change the way you invested?

Summary: Super remains a tax-effective investment environment, but some strategies are clearly more effective in a tax-free pension phase. This article explains some investment considerations for investors currently in pension phase, and for those close to switching on a pension fund.
Key take-out: Holding a property within a super fund and selling it in pension phase will avoid a massive capital gains tax bill, which would be applicable if the property was held outside of super in an individual’s name.
Key beneficiaries: SMSF trustees and superannuation accountholders. Category: Superannuation.

Taxation distorts decision making when it comes to investments. Indeed, taxation distorts a lot of things, including my face when I see my quarterly BAS/IAS.

Tax law can channel investments down one path or another. It can promote or halt some decisions being made at all.

It can stop investors buying, it can stop investors selling, and it can often create situations that the legislators had not considered when framing the law.

One of the best examples I’m aware of is the difference in the taxation treatment of capital gains from property in Australian versus the United States.

In Australia, if you sell an investment property for a gain, you have a capital gains tax liability. No exceptions.

In the US, if you sell a property for a gain, you can avoid paying tax on that gain if the money is reinvested within 12 months. That explains the many big apartment blocks in the US owned by one person – they just keep trading up.

Tax rules make things very different when it comes to superannuation – superannuation is primarily about tax.

But today I’m going to focus on super pension funds and whether the change in tax rules that occurs when you turn on a pension should impact on your investment decisions.

Super taxation basics

Superannuation has two tax phases. As SMSF trustees know, a fund in accumulation phase pays 15% tax on income and, effectively, 10% tax on capital gains.

However, a super fund stops paying tax when it becomes a pension fund. At that point, income is taxed at 0% and capital gains are taxed at 0%.

(I’ll revisit the former Gillard government’s planned special rules for pension funds earning $100,000 or more below.)

Becoming a pension fund

So, when a super fund stops paying tax, should the way you approach investing change?

Importantly, it doesn’t have to. You might decide that the way you’ve always invested has worked well for you, so you’re unlikely to change anything.

But you would be being foolish if you thought it should have no impact on you at all. Even subtly, it should impact on your decision making.

Income versus gains?: Simply, in accumulation, income is taxed at 15% and capital gains are taxed at 10%. Income tends to be a lot more predictable than capital gains, which are highly unpredictable and can, of course, be negative. Given that your income will get a bigger tax break (what you get to keep rises from 85% to 100%) than your capital gains (which only increases from 90% to 100%), would that change the way you treat the chase for income over gains?

Capital gains: For example, if you’ve been holding on to an investment (say, Commonwealth Bank shares) that you bought in the initial float in the early 1990s for a couple of dollars each, you are sitting on a share price gain of about $70 a share.

Sell that in your super fund before you turn on your pension and you would lose, very roughly, about $7 a share in tax (or, if you want to take the glass half-empty viewpoint, about three times what you initially paid for them).

There would be many approaching super pension age who would be deliberately holding out on selling some big gains until they started a pension. (They’re taking the risk, in the CBA’s case for example, that the shares won’t fall by more than the $7 a share in tax that they would save.)

Income: While the returns on cash currently are no laughing matter, they were back in early 2008, when markets were crashing and interest rates were still heading north. At that stage, you could get a term deposit paying north of 7.5 or 8%.

I know, because I’ve heard from them, that plenty of Eureka Report’s readers locked in for three to five years at that stage. An 8% tax-free return? You’d have to consider it, wouldn’t you?

Franked dividends: Franked dividends become even more appealing. As a super fund, a fully-franked dividend of $70 is actually $100, with $30 of tax pre-paid. An accumulation fund will get back $15 of that $30. A pension fund will get the entire $30 back, improving your return on that investment by 17.6%.

Trading: You might have always been a long-term buy and hold investor, rarely selling, even if you did get the timing spectacularly right, buying just before a 30% spike in a share price. In an accumulation fund, you might have said: “well, that’s a nice start to a long-term investment”. In the pension fund, you might say: “Wasn’t expecting that. I’ll take that 30% return in one month off the table right now thanks, and find another investment”.

Would you trade more often? Should you?

That will be a personal question, with no right or wrong answer. But I know that I have consciously decided not to sell for tax reasons and not wanting to pay income tax rates on short-term capital gains, and I know that I’m not Robinson Crusoe in that regard. So I’d safely say that I would certainly consider selling if tax were no longer a consideration to worry about.

Geared property: Is there much point having negatively geared property in a pension fund? Not really. Neutrally and positively geared property is good for pension funds, but negatively geared property doesn’t hold much of a benefit. If you had a negatively geared property and had a choice as to whether to start a pension fund or not – which would depend on factors including whether you were still making taxable contributions – you might hold off starting a pension all together.

Property gains: Certainly one of the big motivations driving many of those people buying geared (and even ungeared) property inside super now is the potential to sell the property after turning 60 and starting a pension, for CGT-free gains. There are a couple of issues with that. One of which includes the potential for legislative changes.

But these investors’ greatest driver is buying the property under those rules. If they bought the same property outside of super in their own names, they would face a big CGT bill if they sold later.

Age wearies them: As most people age, their willingness to take an investment risk wanes. They move out of growth assets (shares and property) and more into income assets (cash and fixed interest). The natural tendency, therefore, is to go more for income assets than growth.

This is not an exhaustive list of the types of different decision making processes that a shift into pension could make for you.

It doesn’t have to change the way you invest. But it probably will. And you’d be kidding yourself if you thought it wouldn’t impact on your mind at all. Tax is an important part of any investment equation. And the thought of paying no tax on investments will, absolutely, have some impact on how you invest.

Fate of Labor’s pension fund tax

Does the incoming Abbott Government spell the end of the proposed tax on pension funds earning in excess of $100,000 of income a year? No, not automatically.

When the new tax was announced (see my column of Busting the super reforms myths), it was to be a retrospective tax that would see an individual’s pension fund taxed at 15% on earnings in excess of $100,000. There were a number of other changes announced also.

The then Opposition told the government to split the changes into various pieces of legislation. The Opposition would allow some of them to pass, including the lifting of the concessional contributions cap from $25,000 to $35,000 for the over 60s for the 2014 financial year.

The new super pensions tax had to be taken to the election. But the Abbott Government has never said that it would not introduce the tax. It has only ever said that there would be “no new unexpected changes” to super. This change could now be argued to be “expected”. So the Coalition could decide to pass the legislation and blame a budget emergency.

And there are rumours that it will do just that. It’s too early to tell. I’ll keep my eye on it.

The information contained in this column should be treated as general advice only. It has not taken anyone’s specific circumstances into account. If you are considering a strategy such as those mentioned here, you are strongly advised to consult your adviser/s, as some of the strategies used in these columns are extremely complex and require high-level technical compliance.

Bruce Brammall is director of Castellan Financial Consulting and the author of Debt Man Walking. E: bruce@castellanfinancial.com.au
Graph for A tax take on pension fund investing

  • The Association of Superannuation Funds of Australia (ASFA) has called for mandatory AFS licencing for individuals or firms involved in the sale of investment products to self-managed super funds (SMSFs). In a statement released last week, ASFA chief executive Pauline Vamos said the association is concerned about the growing number of people being targeted by schemes that offer upfront attractive incentives at the expense of long-term retirement objectives. “Such schemes run the risk of falling foul of the sole purpose test that applies to all SMSFs. As well, provision of large incentives indicates that a property is not being sold at a fair market price,” she said.
  • Industry and retail super funds which lose members to SMSFs are finding it a “one-way valve”, with little prospect of having those members return, according to new research by Investment Trends. According to the research, 6% of those who changed superannuation funds in the past year moved to a self-managed super funds, compared with less than 1% who migrated back from SMSFs to Australian Prudential Regulation Authority (APRA) regulated super funds. “Once members start an SMSF, they rarely ever go back,” Uwe Helmes, senior analyst for Investment Trends reportedly said.
  • Corporate super fund Telstra Super has launched a new investment platform that provides members with direct access to term deposits and shares in a bid to retain members considering SMSFs. The Direct Access option, developed with UBS, gives members access to term deposits with ME Bank, NAB and RaboDirect and also allows members to trade in real time on the sharemarket.

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