Think twice about taking a super lump sum

Sometimes you need an outsider to come in to critique. Rip what you're doing to shreds. And tell you how to reconstruct it properly.

American Professor Robert C Merton has done just that to Australia's super system. On a visit to Australia, the 1997 Nobel Laureate for economics says the way our super funds report to us about our super balances is all wrong.

“What is a good retirement is measured by the standard of living you want in retirement, and standard of living is not defined by a pot of money but a stream of income,” Merton said in an interview in Australia recently.

Merton proposes the way super funds report to us is going to have to change. Telling us the size of the pot of money we have is wrong, he says. Super funds should tell us how much income that pot of money will create.

Take an investment property. The property itself won't put food on the table. But the rental income stream that comes with it will.

Far too many Australians watch their super pile grow, then take it out as a lump sum at retirement.

Something like half of all superannuation is taken out in lump sum format.

But superannuation is really designed to become a pension income stream that will give you a minimum standard of living – above the meagre government age pension – for a few decades to come.

Your super choices when you hit retirement really are:

1. Cash out your super as a lump sum
2. Convert your super into an income stream – a pension
3. Take a mixture of lump sum and pension.

(A fourth option is, arguably, to do nothing. Leave your money sitting in super accumulation, where it will continue to be taxed at 15%.)

Today we are going to ignore transition-to-retirement pensions (for more on these, see Saying goodbye to work … slowly) and other conditions of release and will focus on when you can unquestionably access your super. For most, that will be after turning 65, or turning 60 and retiring.

Lump sums are most often used to pay off the mortgage, or other debt, or for other capital expenditure, such as home renovations, a new car, or a holiday.

And paying off the mortgage can be a good use of that capital, particularly when interest rates are high (which they are not currently). This can also have some advantages when it comes to receiving the government age pension.

I have also written about a study that raised a fear about Australians outsmarting superannuation in this way (see Living today, paying tomorrow: A super dilemma). Knowing their super is coming, many are essentially racking up an equivalent debt before retirement, then using super to repay those extra borrowings.

If you are taking your money out of super, then you need to understand the benefits you'll be missing.

The benefits of leaving the money in super are predominantly three-fold – income streams, zero tax and potential growth. And they all, very deliberately, tie in together.

A tax-effective income stream

After a lifetime of working and building super, it will often be people's second-largest asset apart from their home.

With most modern super funds now, savers have the ability to smoothly move their super to a pension fund and immediately begin a pension income stream.

Because the tax treatment of pension funds is so favourable – they simply aren't taxed – the government insists on savers taking a minimum amount out of their pension, which rises as they age. The government doesn't want savers to keep investing money in a tax-free environment forever.

Zero tax on super pensions

Since 2007, super pensions have been tax-free when taken as an income stream (except for those receiving some untaxed government pensions). However, any income outside of super continues to be taxed.

If you have some shares, or investment properties, outside of super, that are providing you with income, those incomes will continue to be taxed, as per normal.

If you then sell those shares and properties that you hold outside of super, any gains will be subject to capital gains tax.

A super pension, however, will not be taxed. And if your pension fund makes a big capital gain, then it doesn't have to pay tax – which goes a long way to explaining the popularity of investment property in self-managed super funds now.

So, if you pull out a couple of hundred thousand dollars from super and invest it outside of super, then any money that earns will be taxed at your marginal tax rate.

It's still invested

And while you've still got that money in super, you can still have it invested how you want. You can have it invested in most of the same major assets that you would have your money invested in outside of super.

But, as stated above, tax free.

Conclusion

Australians do need to change the way we view super. We do need to understand that converting money into pension income streams is largely in our best interest, although there are occasions when it makes more financial sense to pull the money out of super.

But it is possible that some of these “free choices” that we currently enjoy could be ripped away from us. The Financial System Inquiry being run by David Murray is only a few weeks away from being delivered. And some hold high hopes – and high fears – about what could be recommended in that report, including the possibility that governments could mandate pensions under some circumstances.

Clarification

I have received some feedback to last week's column in relation to the seven weeks remaining to make changes to your super pensions in order to have them grandfathered for the age pension and Commonwealth Seniors Health Card (see Seven weeks left to sort out your super).

It seems my wording wasn't as clear as it could have been. So, let me make it clearer this week. Super pensions will be grandfathered from the means testing arrangements for those who are in receipt of those two government payments by 31 December, 2014. Any changes you make to those super pensions after that date will see them deemed for income purposes.

If you are applying for either of those benefits after 1 January 2015, your superannuation pensions will be deemed for income means-testing purposes.

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.

Bruce Brammall is director of Castellan Financial Consulting and the author of Debt Man Walking. E: bruce@castellanfinancial.com.au