How to stay under the new super limit

Amongst the number of proposed superannuation changes announced on Friday comes the change to the tax treatment of superannuation funds in ‘pension’ phase, that is superannuation funds paying a pension.

Currently, once a superannuation fund is paying a pension, all the earnings of that fund are tax free. The proposed change is to make the income of funds above $100,000 a year subject to a 15% tax rate – the same rate of tax on income as paid by funds in the ‘accumulation’ phase (that is, superannuation funds still accumulating assets).

If these changes were to pass, there are a number of strategic responses that people with larger superannuation balances might consider, including:

• Superannuation contributions splitting;
• Having more assets outside of superannuation;
• Considering reducing the taxable income of a fund with a loss-making, geared property;
• Keeping super funds in the ‘accumulation phase’;
• Watching the impact of any tax inefficient investments.

More reason to super split

Contributions splitting is something that I think couples should be thinking about regardless of these reforms. Each year, most people are able to transfer up to 85% of the financial year’s concessional contributions to their spouse, if their fund allows. This potentially allows the member of a couple with the higher superannuation balance to split their contributions to their partner.

The benefit of having more even superannuation balances is that a couple might be better placed to avoid tax on higher balances or income in the future. For example, a couple with $3 million all in one person’s pension account would face a 15% tax on earnings above $100,000 under the Government’s proposal. However, if one member had $1.8 million and the other member $1.2 million, they still have the same level of combined assets and are far less likely to be impacted by the tax on earnings above $100,000, or any similar future proposal.

Keeping assets outside of superannuation

This change also increases the attractiveness of having some non-superannuation assets in retirement. The ‘Senior and Pensioner Tax Offset’ (SAPTO) means that a couple of age-pension age can generate $58,000 of income (2012-13) from non-superannuation assets and effectively pay no tax. It will generally take more than $1 million of assets to provide this level of income – meaning some people facing the 15% tax on superannuation pension fund earnings of more than $100,000 might consider transferring some superannuation assets outside of super.

Negatively gearing a property

The introduction of the ability to purchase a property using borrowed money (through a nil recourse loan) in superannuation offers an interesting way to reduce the taxable income of a person expecting to generate more than $100,000 of income in their superannuation account at retirement – or someone expecting to be in that situation at retirement.

They might choose to reduce the income of their fund by borrowing to invest in a property that generates a loss, and therefore reduces their taxable income. But keep in mind that borrowing to invest is generally considered a strategy for people with a long investment timeframe, whereas someone at or approaching retirement may be more concerned with short and medium-term investment outcomes. Liquidity (the ready access to cash) is an important part of any superannuation fund paying a pension, and this should be considered if thinking about generating a loss from an investment (which absorbs cash) and investing in an illiquid asset like property.

Reasons to remain in accumulation phase

Currently, one major advantage of converting your superannuation from ‘accumulation’ (the name for a pre-retirement fund) fund into a pension phase is that while your accumulation superannuation assets are taxed at the rate of 15% (and 10% for discount capital gains), your pension fund earnings are taxed at 0%.

However, with the income earned on pension assets above $100,000 a year now taxed at 15% as well, there is no tax difference between having assets in the ‘accumulation’ phase and assets that generate more than $100,000 per year of income in the ‘pension’ phase. This may lead to people who are not spending all of their pension income, choosing to retain those assets that generate income of above $100,000 a year in an ‘accumulation’ account. The benefit of this is that these funds will continue to grow in the relatively tax-advantaged environment of super, without you being forced to draw a minimum amount from these funds each year.

Limiting exposure to tax-ineffective investments

A final change for people with superannuation accounts in the pension phase that generate more than $100,000 of income each year is that they will now have to be wary about the taxable income produced by their investments. Currently, the 0% tax rate on superannuation funds paying a pension means that there are no tax concerns for investors with superannuation pension funds – with the possible exception of wanting to generate a reasonable level of franking credits to receive an attractive tax refund. Now investors will have to be careful to limit their exposure to tax ineffective investments like managed funds that create large distributions through high levels of trading, or hedge funds with aggressive hedging and trading strategies that create high levels of distributions, so as limit the amount of income from a superannuation pension account above $100,000.

Conclusion

Overall, the proposal to tax the income from superannuation funds in the pension phase that is above $100,000 leads to a number of strategic responses for investors who might be impacted by the change. Starting to consider which changes might make sense will put you in a position to respond, should the changes come into law.

Deferred Lifetime Annuities

Meanwhile, in Friday’s superannuation announcement there was also a general statement of the tax treatment of deferred lifetime annuities – annuities that provide income beyond a person’s life expectancy. That is, if a person outlives their ‘life expectancy’, the annuity provides ongoing income payments. This addresses the ‘longevity risk’ that comes with annuities that only provide income for a set number of years, with the risk of the annuity owner outliving the income payments.

The statement from Friday’s announcement on superannuation reform was that deferred lifetime annuities will receive the same concessional tax treatment as earnings for other pension products.

The increased tax effectiveness of deferred lifetime annuities may see an increase in people putting some of their retirement capital into this style of investment – as a ‘low-risk’ part of their overall retirement strategy.

• Later this week Eureka Report will be publishing an article specifically on deferred annuities.

Scott Francis is a personal finance commentator, and previously worked as an independent financial advisor.