Taxed at 93% ? that's gotta hurt!

PORTFOLIO POINT: Ignorance is no defence. Here’s what you need to know to avoid copping a 93% tax rate on your super contributions.

Back in the early 1980s I had a commerce class I’ll never forget, in which we were introduced to the concepts surrounding income tax. I got that the government needed to tax workers to pay for services. No surprise there.

What surprised me – although this won’t be news to many Eureka Report readers – was finding out that the top tax rate in Australia then was 60%. And it cut in at just $50,000. (I am further shocked to learn that it had once been as high as 75% in the 1950s!)

My lecturer went on to say that the Prime Minister of the day – I think the class was about 1984 or 1985, so it would have been Bob Hawke – earned about $150,000 a year. On that salary, the PM was paying more in tax than he was receiving in his hand. That floored me.

Why would a government need to take more than half of what anybody earned? How could that possibly be justified?

Subsequently, the top tax rate in Australia was quickly lowered. For a while it sat at 47% (plus the Medicare levy) and is now 45% (plus the Medicare levy).

There is one higher tax rate. The rate of tax for unearned income for minors is a whopping 66%, which is designed to discourage income being ploughed into the name of children.

Surely, that’s got to be the highest rate. Well, actually, it’s not.

The highest tax rate in Australia is actually around 93%. That’s right – NINETY THREE PERCENT. And, it applies in the area of superannuation, which, bizarrely, is designed to be a low-tax environment to save for your future.

And the worst part of it is that an inadvertent error – even as little as a few dollars – could lead you to having a Very Big Tax Bill.

Unfortunately, the errors that lead to such harsh penalties can be quite simple to make. It might not even be your fault.

Contribution limits and taxes – the basics

First, a quick refresher in what you should already know. There are now only two sorts of contributions in super and both of them have strict caps, designed to limit the amount of money people can put in.

Firstly, there are concessional contributions (CC), largely pre-tax dollars. These include the Superannuation Guarantee made by your employer, salary sacrifice contributions, and eligible contributions made by the self-employed. The cap for CCs is $25,000. If you’re over 50, then you have a temporary cap of $50,000 until June 30, 2011.

Concessional contributions haven’t been taxed before and are taxed at just 15% as they enter the fund, as an enticement to put money into super for retirement savings instead of receiving it now.

The other contributions are non-concessional contributions (NCC) and they have a limit for the eligible of $150,000 a year. This is money that has been previously taxed. It can include your take home salary, money remaining after tax has been paid for capital gains, savings, etc. You might have paid up to 46.5% in tax on this if you had taken it as salary.

This money has already been taxed, so it is not taxed again on its way into the fund.

Three year pull-forward rule

There are strict annual caps for concessional contributions, but the rules surrounding NCCs allow members to put in up to $450,000 in a single year, which is taken as a “pull-forward” of the following two years. So a $450,000 contribution prevents you making further NCCs for the year in which the contribution is made, plus the following two financial years.

Scenario 1:

So, how can superannuation savings be taxed at 93%? The problems begin if you start breaching either limit. To use an example, we’ll assume a 55-year-old employee, Anne, who is earning about $120,000 a year.

Her employer is chipping in 9% of her salary, or $10,800, into her super fund. Her mortgage is paid off, so she’s in a position to maximise her salary sacrifice contributions to her super fund. She calculates she can salary sacrifice $39,200 into her super fund, which takes her to $50,000.

However, she got a one-off $20,000 bonus in May. The payment was treated as salary, so the employer paid another 9% of that figure, or $1800, into her super fund. She didn’t think anything of it.

But that meant her contributions for the year now came to $51,800 and she’d breached the CC cap. Under the rules, that extra $1800 is then treated as an NCC. Because it hasn’t been taxed before, penalty tax of 31.5% is applied to the $1800, plus the 15% contributions tax. So, of the $1800, only $963 makes it into the super fund.

Separately, Anne’s mother had died a year previously. From the estate, Anne and her siblings had picked up a reasonable sum of money.

As the estate was being settled, Anne put in a $150,000 NCC into super. The following year, Anne had decided to make a $450,000 NCC, putting her right on the edge of the limits for NCCs.

Anne’s intention was to be right on the edge of her CC and NCC limits. However, the unexpected and unplanned bonus payment and related super contribution made by her employer had triggered some unexpected consequences.

The extra $1800 from the 9% SG payment from her bonus took her over her concessional contribution limit and was now being put down as an NCC contribution. However, she’d already contributed up to the limit of $150,000 for NCCs for that year, so this $1800 put her in excess of the pull-forward rule because she had now been deemed to have made $151,800 in NCCs.

So, when she put in the extra $450,000, she had now actually gone $151,800 over the NCC limits for the three years. This excess of $151,800 is now taxed at 46.5%. She will now lose $70,587 of this in excess contributions tax.

Scenario 2:

Paul was in a similar position. An unplanned for super contribution of $5000 had pushed him over the $50,000 CC cap and now counted towards his NCC cap.

Paul had put in $450,000. Because he had breached his CC cap, the extra $5000 counted towards his NCC cap. And he’d now breached the $450,000 pull-forward limit.

Because the $5000 that was now reclassified as NCC, it will now be taxed at an extra 31.5%. However, as he’s also busted the NCC limit, the excess will be taxed at a full 46.5%. So, of the $5000 “accidental” additional contribution, only $350 will make it into Paul’s super fund. (The original $5000 was taxed at 78% – 31.5% plus 46.5% – plus the original 15%, giving a total tax take of 93%).

Sadly, there are many ways small errors like this can be made. I warned about this at the time (see Beware super’s penalty zone), but it appears that it became a particular problem for those who did not adjust their salary sacrificing contributions when the CC limit was dropped from $100,000 to $50,000 for the 2010 financial year. Many of those were also approaching their NCC limits and pushed into the penalty tax area.

How do you avoid the penalty tax rate?

Simply, as a trustee of your SMSF, you have to pay strict attention to what’s being contributed to your fund.

Ignorance is no excuse. The tax office doesn’t accept “honest mistake” in this area. You can apply for “special circumstances” consideration, but few applicants succeed.

The tax office and relevant ministers have been aware of this issue for some time. But, for the most part, they seem unwilling to change the rules because that would only encourage breaches.

And, unfortunately, it is a rule that is most likely to affect SMSF members, because they tend to have far higher balances and are far more likely to make NCC contributions that may get them close to the limits.

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 advised to consult your financial adviser.

Bruce Brammall is director of Castellan Financial Consulting and author of Debt Man Walking.