Transition to more super

PORTFOLIO POINT: Ramping up your non-concessional contributions before starting the pension can aid transition-to-retirement plans.

There’s little doubt that transition to retirement strategies have been, well, neutered, to a large extent, in recent years.

If you were aged 55-59 and all of your super was in the taxable component (that is, predominantly concessional contributions), then the major benefit for your super balance was having a super fund in pension phase, where it didn’t pay tax (which, depending on your situation and super balance, could be significant).

If your super had a tax-free (or non-concessional) component, then there was some benefit for those aged 55-59 years of age. The higher the tax-free portion, the larger the benefit.

For those who wanted purely to salary sacrifice, then the benefits were swapping your marginal tax rate (of up to 46.5%) for the super contributions tax rate of 15%. And to read how the new marginal tax rates are beneficial for that strategy, see last week’s column.

Having a tax-free portion in your super – which most people build via non-concessional contributions with after-tax money being contributed to their super – can make a significant difference to the impact of a TTR pension strategy.

Take a 55-year-old starting a TTR pension. He has $200,000 in his super fund and earns $60,000 as an employee, with 9% superannuation guarantee contributions made on that.

We’ll assume that our pensioner’s current after-tax income is sufficient and they would like to maintain that level of income. Also, we’ll assume a flat 7% growth rate (3.5% income and 3.5% capital growth).

All taxable
If our pensioner’s entire super fund was taxable, then to maintain the same income, he would start by salary sacrificing $19,600 a year. This, when added to the $5,400 SG from his employment, would take him to the $25,000 concessional contributions limit.

He would then need to draw a pension income of $15,920 to make up for the income being salary sacrificed. That’s 7.96% of his total super balance – within the range of TTR strategies of 4-10%.

Inside the super fund, which is now in pension phase and therefore tax-free, the super fund should have added an extra $2,601 (given our return assumptions).

There are some other benefits, including increased access to the mature-age worker’s tax offset and the low-income tax offset. However, they’re fairly small. The benefit of the compounding returns in the tax-free pension, between 55 and 59, means an extra $16,518 in super at age 60.

Then, when the super pension becomes tax free, the benefits really kick in. By age 65 (and our assumed retirement), an extra $68,000 will have been added to super.

Tax free component of 25%
The main difference here is that we’ll now assume a tax-free component of 25% of the super fund. That is, of the $200,000 in super, $50,000 has come from non-concessional contributions and makes up the tax-free component.

They are still salary sacrificing to the maximum level allowed. Given that 25% of the pension income is now tax-free, the pensioner would only need to draw $14,960 – nearly $1,000 less – in order to maintain the same income, which keeps that money inside super.

Inside super is where the real difference is happening. The increase in the total super balance in year one should be around $3,600. Between 55 and 60, the increase in super is $21,565.

And between 60 and 65, when the pension is tax-free, the super balance grows to be around $75,000 higher at retirement.

Tax free component of 50%
Now, we’ll assume half of the super fund at the point of turning on the pension is tax-free. That is, of the $200,000 in the pension fund, $100,000 is made up of non-concessional contributions.

Total personal taxation falls as the level of tax-free in the pension fund increases, because of the income coming from the pension fund is already tax free income.

Our pensioner is still salary sacrificing $19,400 a year to hit their target of $25,000 a year in concessional contributions, but now only needs to take a pension of $14,000 in order to maintain his income, with the remainder staying in the pension fund, earning further tax-free returns.

In the first year, the benefit to the super fund of not needing to take as much of a pension and the zero-tax environment is that it should be nearly $4,500 higher.

At age 60, the combined super should be around $26,100 higher. And at age 65, around $81,400 higher.

What to remember
The same after-tax income (rising with inflation) has been maintained throughout the examples.

The main benefit from a TTR strategy if your fund is solely made up of concessional contributions comes from the pension fund itself being tax free. There are some other benefits that come with the salary sacrifice side of the strategy, in increased tax government offsets.

But while the benefits might be on the small side prior to age 60, they exist and they really start to ramp up once the pensioner turns 60.

It’s important to note that we have assumed returns within super of 7%, split evenly between income and growth. Obviously, some years, like the year just completed, that didn’t happen.

If you’re of the opinion that growth rates could be stronger in the next few years – that is, if you believe in the principle of reversion to mean because we’ve had five years of very little – the benefit to your super fund of not paying tax on income and gains becomes more significant.

Considerably larger super funds, obviously, have the potential to make greater use of being tax-free. A $1,000,000 fund earning $35,000 in income and another $35,000 in capital gains, neither of which is taxed, can be of considerable benefit.

But a higher pension (between $40,000 and $100,000 would have to be taken, which might be too much for the pensioner. But further strategies could be employed there, including potentially putting some of that excess income back into super as a non-concessional contribution (a topic for another day).

Uncertainty continues over potential changes to in-specie (off market) transfers into self-managed super funds, as the federal government remains officially silent on the issue. Transfers were expected to be banned from July 1, meaning assets such as shares would need to be sold on market, and then re-purchased within the super fund. Currently these assets can be transferred simply through registry forms. However Cavendish Superannuation’s David Busoli pointed out no legislation has been introduced, and Super Guide reports the ban is widely expected to be deferred until July 2013. The office of the relevant federal Minister, Bill Shorten, has not yet provided a statement on the changes, and trustees considering asset transfers should be aware of the uncertain legislative framework around this issue. The income and asset test for the Age Pension has been updated again with the new financial year, and those who narrowly missed out are being urged to look at their financial situation again in light of the shift. At the same time, Towers Watson has called for ASIC to amend its requirements on retirement estimates so that they include contributions from the age pension, according to reports. The age pension is not required to be factored into retirement income estimates currently, though it will affect many retirees. SMSF Academy’s Aaron Dunn points out that since last year, the baby boomers have entered Age Pension eligibility, so this is a feature which will become increasingly relevant in the coming years. The SMSF Professionals Association of Australia has called on the Australian Taxation Office to make a clear ruling on when a super stream starts and ends. SPAA director of education and professional standards Graeme Colley said the draft ruling would have significant impacts. “Certainly there is the potential for significant additional income tax to be paid if the trustees get it wrong,” Colley said. “SPAA understands a decision was to have been made by last month, but nothing has been forthcoming despite numerous submissions on the issue to the ATO.” Macquarie Advisory Services has improved its term deposit offering for SMSFs, according to reports. The company said managing term deposit maturities could be laborious, and through the introduction of online capability and allowing advisers to manage this on behalf of clients this workload would be reduced.

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 highly complex and require high-level technical compliance.

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