Summary: As a plan for higher super taxes for high income earners is on the table, it’s a good time to consider the power of super to create wealth over the long term. At the moment, concessional super contributions are only taxed at 15 per cent, as are investment earnings in a super fund. In our case study, a high income earner with 25 years to retirement and surplus income of $10,000 per year will growth their wealth to double the amount by investing in super compared to investing outside super.
Key take-out: We might be facing the last opportunity that we have for a 15 per cent contributions tax for superannuation – many of us will be thinking about whether we should take action on that, and get more money into superannuation now.
Key beneficiaries: General investors. Category: Superannuation
It seems inevitable that changes are coming to superannuation. In fact, this may be the last chance for many people to get money into the low tax superannuation environment with a 15 per cent contributions tax, as the Government considers a plan for higher superannuation tax rates for higher income earners. This situation is certainly not unprecedented in Australia – many people will remember the superannuation contributions surcharge that was abolished by the Howard Government in the 2005 Budget. It was, effectively, a higher superannuation contributions tax rate for higher income earners.
If we are in the midst of the last opportunity for high income earners to make concessional superannuation contributions (for most people their employer contributions and salary sacrifice contributions) taxed at a 15 per cent tax rate, it is worth considering the power of superannuation over long periods of time to create wealth.
The end of 15 per cent super tax?
There are two “tax levers” that superannuation gives investors.
The first is that concessional contributions (for example employer contributions and salary sacrifice contributions) are currently only taxed at 15 per cent. This is generally a lower tax rate than if this money was taxed as income, where it might face a tax rate of up to 45 per cent plus 2 per cent Medicare levy plus 2 per cent Budget repair levy.
The second tax lever is that investment earnings in a superannuation fund are only taxed at 15 per cent (or 10 per cent for long-term capital gains).
The value of superannuation – doubling your end wealth
It is interesting to consider what this might be worth over an extended period of time. For a case study, let’s consider a person with 25 years until retirement who has surplus after tax income of $10,000 per year. Let’s also assume that they are in the highest tax bracket – they pay tax and Medicare levy at the rate of 47 per cent. (We will ignore the Budget repair levy given that it is intended to only be a temporary measure).
The aim of the case study is to compare what might happen to that money if this person built an investment portfolio in their own name, compared to the results if they used the tax benefits of the superannuation environment.
Let’s assume a portfolio of 60 per cent Australian shares and 40 per cent cash. Let’s also use returns for the 20 years to the end of December 2014 from the ASX Perpetual 2015 long-term investing report, which provides after tax returns for an individual on the highest tax rate for money invested outside super. This allows us to calculate that the average annual return for that asset allocation (60 per cent Australian shares, 40 per cent cash) is 5.3 per cent per annum after tax. After 25 years of saving and investing $10,000 per year, that amounts to the reasonably impressive sum of $510,676.
We need to consider what happens if we invest that money in superannuation. The first lever of the tax efficiency of superannuation is the lower tax rate on contributions. A person on the top tax bracket has to earn $18,868 to have $10,000 per year left to save. However, if they were to salary sacrifice this amount to superannuation they currently only pay 15 per cent contributions tax, leaving them with an after tax superannuation contribution of $16,038.
It is important to note that a worker in the highest income tax bracket might not be able to make a salary sacrifice contribution of this size, as it may put them over the $35,000 contributions limit (if aged 49 or older), or the $30,000 contributions limits for everyone else. However, because the focus of the calculation is on comparing superannuation returns with non-superannuation returns, we will ignore this element that certainly might limit the extent of a salary sacrifice strategy for someone on the top tax bracket.
The same long-term investing report suggests that the same portfolio of 60 per cent Australian shares and 40 per cent cash, invested in the superannuation environment, would provide an after-tax return of 7.18 per cent per annum, significantly more attractive than the 5.3 per cent per annum returned when taxed at the top income tax rate.
The results of the salary sacrifice strategy: $10,000 per year of after-tax income for someone on the top tax bracket equates to an annual salary sacrifice contribution of $16,038 after contributions tax which, with average annual earnings of 7.18 per cent, would grow to $1,078,357. This is more than twice the value of the non-super portfolio (which grew to $510,676) where both income and investment returns were taxed at the highest tax rate.
Considering a middle tax rate (37 per cent)
For someone on the 37 per cent tax rate (earning income of more than $80,000 and up to $180,000), the value of investing in superannuation is also clear. Over 25 years, $10,000 per year of after tax income would increase in value to $586,116 outside of superannuation in this case study. If someone on a middle tax rate salary sacrificed an amount equivalent to $10,000 of after tax income, and invested in the lower tax environment of superannuation, under our assumptions they end up with $936,889.
The very fact that there is so much talk about likely superannuation rule changes is one of the disincentives of superannuation; the rules keep changing. Be that as it may, the low tax environment of superannuation is a great environment for creating wealth. We might be facing the last opportunity that we have for a 15 per cent contributions tax for superannuation – many of us will be thinking about whether we should take action on that, and get more money into superannuation now.
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.