It's time to look beyond super savings

In common with many commentators I have been very strongly supportive of investors taking advantage of DIY superannuation funds for a long time. However, in thinking about 2015 and the key issues that may be relevant to my area of concern I find that investing outside superannuation, especially when you are already retired could become considerably more rewarding.

Why? Well, two things have happened in the last fortnight that might act together to make superannuation less attractive than it has been. Most recently the mid-year update to the budget highlighted the deficit problems that the Treasurer has on his hands – not just in the current year but into the future. Before that the David Murray-chaired Financial System Inquiry Report was released, with a focus on the banking system but including thoughts around superannuation. This included the idea that ‘Aligning the earnings tax rate between accumulation and retirement would reduce costs for funds, help to foster innovation in whole-of-life superannuation products, facilitate a seamless transition to retirement and reduce opportunities for tax arbitrage' (Appendix 2: Tax Summary). Simply translated, the report suggests benefits in having the same tax rates for superannuation funds regardless of whether they are in accumulation mode (currently 15% with a discount for long-term capital gains) or pension mode (0%). 

The reality is that superannuation is a massive and growing pile of assets, with significant tax advantages (read: costs to the Government), that must be on the radar of any treasurer looking for ways to balance the country's books. The Australian Prudential Regulation Authority put the size of superannuation assets at the end of the June quarter 2014 at $1.85 trillion. A way to tax this at an extra effective tax rate of 1% per year would provide $18.5 billion in tax revenue, a quantum of money that would be very helpful in supporting the budget bottom line.

The specific suggestion of taxing superannuation funds paying a retirement pension, if implemented, would see the end to the “tax-free” environment that many self-funded retirees now enjoy. At the moment a retirement fund is, for many people, about maximising superannuation contributions and withdrawing a tax-free income stream from a superannuation fund in pension mode that has a 0% tax rate – and enjoying the rebate of franking credits along the way.

However, it is important to note that this is not the only “tax-free” investment environment that there is. For a person with no other income, the first $18,200 of investment income in their name is tax free – and without the cost and regulation of the superannuation environment.

We don't know at this stage if paying tax in a superannuation fund paying a pension is something that we are going to have to deal with, but it does lead to thinking about the balance of investments inside and outside of superannuation. For most of us when we think of a tax-free retirement we think of superannuation. I am not going to argue with that – superannuation will remain the most important vehicle to fund retirement for most people. The tax benefits on contributions and earnings are a huge benefit. However, I sometimes think that we forget we can have significant assets outside of superannuation, without the cutely named “legislative risk” that comes with a fairly constant flow of rule changes to superannuation, and still pay no tax. With individuals currently able to earn $18,200 before paying any tax (and maybe more with tax offsets), it effectively means that an individual should be able to have investments of around $300,000 outside of superannuation, and a couple $600,000 combined, and pay no tax from these investments in retirement.

Strategic pressures that make a non-super portfolio worth considering

The possibility of having to pay more tax related to a superannuation fund paying a pension is not the only factor that suggests having some assets outside of superannuation might be a good thing. Others include:

- The later preservation ages for superannuation, and age of access to the Age Pension: People who want to retire before their preservation age/Age Pension age will need to have some assets outside of superannuation.

- Mandated pension drawdowns: People taking an account-based pension are forced to withdraw a minimum amount from their fund. This minimum amount increases as they get older. A portfolio outside of superannuation leaves you complete flexibility about how much or little you choose to withdraw.

- Superannuation has significant restrictions to access prior to your preservation age: Having access to investments outside of superannuation when you are in your 40s and 50s provides access to funds prior to retirement, for example, if there is a period where income is reduced.

- Estate planning: The simplicity for a couple of having joint investments outside of superannuation that automatically passes to the surviving spouse is seen as a benefit by many.

- Increased salary sacrifices to superannuation close to retirement: if a person/couple has an investment portfolio outside of superannuation that is providing reasonable income, then they can use that income to partly fund their cost of living, and save tax by increasing their salary sacrifice contributions to superannuation as they get closer to retirement.

- An investment outside of superannuation might be cheaper and simpler: A portfolio of direct shares held in an investor's name without the administrative costs or time of superannuation is about the lowest cost investment that there is.

How you might do this

The current tax-free threshold for each person is $18,200. A reasonable estimate is that a portfolio valued at $300,000 for an individual might produce this level of income. A couple has access to two tax-free thresholds, a combined $36,200 before they have to pay any tax, and a $600,000 portfolio for a couple might produce this level of income. Keep in mind that the value of franking credits is included in calculating income.

Over a working lifetime, there is a benefit in putting investments, and the subsequent investment income, into the name of the spouse who is earning less income and faces a lower tax rate. This makes sense in this situation, and would be the initial strategy. However, looking ahead to retirement, having income in both names to take advantage of two tax-free thresholds will make sense.

People in their 20s and 30s might find that the best use of excess funds is to build some investments outside of superannuation, as well as paying off the mortgage, before increasing superannuation contributions. Those closer to retirement might think about whether lump sums, for example from an inheritance, are invested inside or outside of superannuation. Those who find that they have excess income after making the maximum salary sacrifice contributions to superannuation can use this to build investments outside of superannuation.

You might choose to target a slightly lower amount than the threshold that will take your investment income up to the tax-free threshold. For example, you might target $400,000 rather than $600,000. This gives you a little more flexibility if you want to reinvest income at any time, or if the income grows at a rate greater than the tax thresholds do.

Conclusion

Given the size of superannuation – $1.85 trillion at the end of last financial year – it must be a possible part solution to the current budget woes. The specific discussion of taxing superannuation funds paying pensions reminds us of this, and might make investors think more about building investments outside of superannuation. We often think that a superannuation fund paying a pension is the only tax-free environment for an investor. It is not. Taking advantage of your tax-free threshold in retirement is another step that might make strategic sense.

Scott Francis is a personal finance commentator, and previously worked as an independent financial adviser. The comments published are not financial product recommendations and may not represent the views of Eureka Report. To the extent that it contains general advice it has been prepared without taking into account your objectives, financial situation or needs. Before acting on it you should consider its appropriateness, having regard to your objectives, financial situation and needs.