Making the most of your spare cash depends on your mid-life circumstances, writes John Collett.
It is a question that has probably crossed the minds of many people in their mid-life years who have some spare cash. Is it better to put the money towards paying off the mortgage or into superannuation?
The kids may have finished school or one of the partners may have returned to full-time work and there is some spare cash for the first time in years. But the superannuation balance is not enough to afford a comfortable retirement and there is still a mortgage on the house.
Of course, whatever decision is made is dependent on individual circumstances. Modelling comparing the two strategies - topping up super or paying off the mortgage - has been done for Money by Wayne Leggett, a financial planner and principal of Paramount Wealth Management.
It shows salary sacrificing into super gives a better outcome than putting the spare cash into the mortgage. The accompanying table shows that a person aged 45 who pays interest only on a $300,000 home loan and salary sacrifices $5000 a year (or, about $100 a week) of pre-tax pay into their super would be $33,000 better off by age 65. If the amount salary sacrificed was doubled to $200 a week, the advantage of the superannuation strategy would double to $66,000.
As withdrawals from super are tax-free at age 60 and over, the person could withdraw savings from super to pay-down the mortgage or, ideally, pay it off altogether.
The super strategy is a long-term strategy and there can be unexpected life events where access to super is needed earlier than anticipated. Preservation age, the age at which super can be withdrawn, is between age 55 and 60, depending on when you were born. For those born before July 1, 1960 preservation age is 55 and for those born from July 1, 1964, it is age 60 (see table). But just reaching preservation age doesn't mean you can access your super.
A condition of release has to be met such as permanent retirement or the start of a " transition to retirement" pension, which provides an income stream from your super while you are still working. And while taking the money out of super at age 60 or over is tax-free, regardless of whether you are retired or not, taking the money out earlier than age 60 will likely incur tax.
The superannuation strategy requires discipline, Leggett says. And although the numbers may say that is the best way to go, there are more considerations. "What I tell my clients is that it has to meet the pillow test - when you put your head on the pillow at night-time can you sleep with what you are doing with your money," he says.
Greg Cook, financial planner and co-founder of Eureka Financial Group, says for couples whose mortgage is relatively small, there is no great urgency for them to pay extra on it. They would probably be best off maximising the amount salary sacrificed into super.
Under current super rules, a person is allowed to salary-sacrifice up to $25,000 a year. The $25,000 includes the 9 per cent superannuation guarantee, so someone on $100,000 a year can put up to $16,000 a year of their before-tax pay into super.
By salary sacrificing, they are replacing their marginal income tax rate, which for those earning between $37,001 and $80,000 a year is 32.5 per cent, plus the Medicare Levy of 1.5 per cent, with a superannuation contributions tax of 15 per cent. For each dollar salary sacrificed there is a tax saving of 19¢. The higher the marginal rate of income tax, the greater the tax break. Those earning between $80,001 and $180,000 are on a marginal income tax rate of 37 per cent plus 1.5 per cent Medicare. They will have a tax saving of 23.5¢ for every dollar salary-sacrificed into super.
Mortgage may be better
While the numbers show that salary sacrificing is better, there is the wait to age 60 to withdraw the money from super tax-free. And Cook says that, for many people, salary sacrificing is a struggle to understand and their default position is to pay more on the mortgage. If their mortgage is large, it may make sense to put any spare cash to work on reducing it first before topping up their superannuation savings.
John Hewison, a financial planner and founder of Hewison Private Wealth, says the tax breaks on superannuation make it likely to be the best strategy for most people. But many people like to clear the mortgage or reduce the mortgage balance first. And by using a mortgage offset account, they can redraw the extra repayments if needed. Not every mortgage has an offset account, but most do. The way offsets work is that the interest that would be earned on the money sitting in the account is deducted from the mortgage balance.
Better than investing
Regardless of whatever way is used to get ahead financially - whether it is paying more off the mortgage or salary-sacrificing in super, they are both highly likely to be better than using the spare cash to make an investment. "Balanced" investment options earn about 7 per cent over the long term, after fees and taxes. And mortgage interest rates are about 6 per cent. Both super and the family home are tax-effective. Super, because it can be salary sacrificed with a contributions tax of only 15 per cent, with a tax of only 15 per cent on earnings inside super. And there is no capital gains tax payable on the sale of the family home.
When compared with paying down the mortgage, an investment would have to return at least 6 per cent after all fees, costs and taxes just to equal the mortgage. It would have to produce a total return (income plus capital gains) of more than 9 per cent, because of the fees, costs and taxes, just to start being as good as paying off the mortgage.
John Dani, manager of advice development at ipac Securities, says paying off the mortgage is a "risk-less" investment. The effective rate of return changes only with changes in the interest rate. To achieve earnings of the 9 per cent on an investment, there would have to be exposure to risky assets such as shares and property, he says.
Getting ahead This is the first in a three-part series on maximising your money. Part Two — on strategies for paying off your mortgage earlier — will be in Weekend Money, with Sunday's Sun-Herald.