Comparing the SMSFs pair: Income vs growth

Summary: Income versus growth – the trade-off equation to consider for your self-managed super fund. Plus the Tax Office relents a little on TBAR.

Key take-out: Income and growth in a SMSF are very different, and the path a member decides to take will depend on their risk profile. The incentive is there to chase capital gains considering the tax imputations, but it also comes with a greater risk of capital losses. 

The Australian market has popped its head above 6000 points and the chase for growth by super funds appears to be back on.

After a hiatus, where the Australian market bounced between 5600 and 6000 points for about 11 months, the market finally broke through that upper barrier and stayed there. For a few days, at least.

The market hasn't been without returns during that 11-month lead-up period – our nation's obsession with dividends has meant income while we wait.  

But if market sentiment stays positive and we're about to head into another growth phase, it is probably important to consider your own priorities for growth or income again.

Income and growth in a SMSF are very different. And what you should be chasing will depend on your risk profile.

As the saying goes, you can buy a meal with income, but not with equity (without selling an asset). Income tends to be surer than growth. And the way income and growth is treated from a tax perspective is also different.

For super funds, the tax paid depends on when the funds are received. That is, income is taxed in the year it is received, while capital gains are taxed in the year the gain is made.

Income is taxed at 15 per cent. Meanwhile, capital gains in a super fund are taxed at 15 per cent, but with a one-third discount on the gain, so the equivalent of 10 per cent.

The incentive is there to chase capital gains. But it comes with a greater risk of capital losses. And there is usually a trade-off between more highly reliable income streams and the possible capital gains.

This could be the difference between the high-dividend payers – the likes of the banks, Telstra and Wesfarmers – and lower dividend growth stocks. Traditionally, that is CSL, our bigger resource companies, and small cap stocks, which are usually reinvesting earnings for growth.

Let's assume for a moment that, over an extended period, the total returns even out at 9 per cent. (Unlikely, but let's just look at it from a tax perspective.)

We'll take two 50-year-old investors with a $500,000 SMSF portfolio. One will receive income of 2 per cent and growth of 7 per cent, while the other will get income of 5 per cent and growth of 4 per cent. We'll assume both SMSFs are making long-term investments – as a result, we'll ignore capital gains, which may be sold tax-free when the super fund's pension is turned on.

We'll ignore costs of the super funds, as they should be similar. For simplicity, we won't include any contributions into the equations. They would simple accelerate any differences.

The main difference in total super balances will come from the higher tax take on the income being received by each fund.

The difference a decade of tax makes

The 10 years before the age of 60 is the first time period to note. This is the point where pensions can potentially be turned on.

At that point, the high-growth investor is now sitting on a portfolio value of $1,152,504, while the income-based investor has $1,104,712.

The higher-risk investor, largely because of the income-tax difference and the ensuing compounding, is ahead by $46,792.

At age 65, the differences in portfolio values have widened to $105,425 – from $1,747,484 and $1,642,058. And if the portfolio stays in position until age 70, the growth investor is now $211,146 ahead ($2,651,923 vs $2,440,777).

A fair comparison?

Probably not. And the growth investor would probably not be happy with a larger return of just that amount, given the extra risk to capital that their SMSF has taken on. The growth investor would want to earn several more percentage points to justify the risk, but this exercise is only designed to show the extra return that can be achieved from tax.

When the two super funds go into pension phase, they would be able to sell their shares CGT-free.

Higher income tax is generally what is going to be paid for the surety of the income streams.

Changes to events-based reporting rules

The Australian Tax Office has made some reasonable concessions to its draft plans concerning the need for SMSFs to report events that impact on a member's transfer balance amount. This reporting procedure has been referred to as real-time reporting (see our article, A reporting reprieve for SMSFs).

The transfer balance cap report (TBAR) was going to require all super funds to alert the ATO to member account balances when, particularly, withdrawals were made that would reduce the transfer balance cap.

The new rules that exist around the $1.6 million pension transfer balance cap (PTBC) made it advisable, for members who were going to take more than the minimum pension, to take any extra capital as a commutation. This would reduce their PTBC, allowing them to potentially add to their PTBC when further capital was received – an inheritance, the sale of an asset, or another windfall.

That is, if you had a $1.6 million pension and you needed income of $164,000 for the year, you would take the minimum pension of 4 per cent ($64,000) and the remaining $100,000 as a pension commutation. This would have the impact of reducing your transfer balance account to $1.5 million.

For more information, see my column, The ATO raises the TBAR on pension reporting.

But the ATO has announced it will only be members with balances of more than $1 million that will have to announce their TBARs to the ATO. This will apparently only affect about 15 per cent of SMSF members.

As expected, those needing to meet TBAR requirements will have 28 days to do so.

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.