Which assets should I put in my SMSF?

Background

Let’s state the obvious first; all profitable investments will produce better after-tax returns held in super, due to the lower tax rates, than in, say, your own name. But the additional benefit of investing via super is not the same for every one.

Yield-oriented assets like bonds, hybrids and dividend-paying shares get more benefit from being held in super than growth investments like residential property and growth-orientated shares.

So it’s important to understand what asset is best held where and what drives the decision.

Our skewed tax system

Australia has a tax system that incentivises speculation over income generation. The key culprit is the concessional capital gains tax (CGT) rates, especially when combined with upfront deductions at marginal tax rates for negatively geared investments.

Once an asset is held for 12 months, CGT is only charged on half the gain. Effectively, this means capital gains are taxed at half the rate of ordinary income like dividends, interest and rent (23.25% vs 46.5% for someone on the highest marginal tax rate).

Our superannuation tax system doesn’t contain the same subsidy for speculation. In accumulation mode, ordinary income is taxed at 15% and capital gains at 10% (assuming the assets are held for 12 months). In pension mode, no tax is payable at all.

Table 1 shows the marginal benefit of holding  an income-only compared with a growth-only investment in super. Over the long term, the additional returns to the income investment really add up.

Case study

Let’s assume you have $200,000 to invest—$100,000 in super and $100,000 in your own name—and have the two investment choices set out in Table 2.

In a pension-mode SMSF, these two investments, with no tax to worry about, each return 8% per annum. But with tax in play, the different components cause the after-tax returns to be quite different. Held by an individual, the growth investment will substantially outperform the income investment.

It will outperform in a 15% (accumulation mode) SMSF too, just not to the same degree. Table 3 demonstrates the point. Over a 20-year term, using a 15% SMSF for the income investment is like having an extra $32,043 to invest at the outset. For the growth investment it only amounts to $18,027.

Now let’s look at what happens when you hold one asset inside, and one outside, your SMSF.

Table 4 shows the benefit of getting the allocation ‘right’. An extra 0.4% per annum in after-tax return, or $10,714 (in real net present value terms) on a $200,000 total investment. In case you are wondering, changing the marginal tax rate to 38.5% doesn’t make much difference to the result.

Scenarios

When examining an investment or strategy, you need to understand how it plays out across a range of scenarios. Too many investors make the mistake of confusing assumptions for reality, failing to appreciate that the upside was unlikely, and the downside ugly.

In Table 5 we’ve repeated the analysis from Table 4 with a low and high growth rate. You can see that the ‘right’ allocation gives an even better result in the downside case but is not as good on the upside.

Having a strategy that works better as things get ugly makes good sense. You don’t end up with any benefit with a high rate of capital growth, but extra tax is tolerable when you’ve just had an unexpected success.

Counter arguments

Not everyone will agree with this analysis so let’s consider the alternative views.

Firstly, growth assets should deliver higher overall returns and, when your SMSF switches to pension mode, you get the benefit of CGT falling to zero.

Well, as the last five years shows, growth assets don’t always outperform and changing the CGT rate to zero improves the returns of the ‘wrong’ allocation only slightly (the combined return in Table 4 increases to 5.73%). The benefit of not having to pay CGT is too far into the future to have much impact on the numbers.

Over a shorter term, with higher capital gains and a zero CGT rate, the benefit of putting a growth asset in your SMSF would be substantially greater. But who’s that confident about generating gains over a short time frame. And if you were, why bother with the income investment at all?

Laws may also change. Rumours that the CGT rate for pension mode SMSFs might be revised circulated at the time of the mid-year economic outlook. Over the long term you simply can’t assume the status quo.

Second, there are practical reasons for holding income investments outside super; they’re more liquid and are available to pay expenses and cover contingencies.

Can’t argue with that. There may be practical reasons why the maths should come second, at least to a degree. Everyone, especially those a long way from pension age, should hold a reasonable amount of liquid assets outside their SMSF because you never know what the future holds.

Other factors to consider

There are many restrictions and requirements associated with holding certain assets in super.

For example, residential property, collectibles and personal-use assets such as art, are subject to a range of special rules that don’t apply to other investments. Most of these are growth assets.

If you’re going to hold art in super, you may find that, not only are you subjecting yourself to special storage, insurance and valuation requirements but you really aren’t getting much financial benefit from doing so, either.

Unless the numbers are compelling (which probably requires inside knowledge), then assets such as art don’t hold much appeal as SMSF investments.

Final thoughts

Getting the asset mix right is one of the simplest ways to get the most from your SMSF. As a rule of thumb and subject to the caveats above, if you have to choose, put your income assets in super and your growth assets outside it. That’s basically the essence of it.