How tax affects the superannuation equation
Even with proposed changes, super is still attractive.
With changes to superannuation on the way, self-funded retirees and long-term investors who can overlay their investment strategy with in-depth knowledge of the tax regime may find they have opportunities to enhance their final returns without needing to take on higher levels of risk.
Even considering proposals on the table, from both political sides, the effectiveness of superannuation should not be written off. It offers a very favourable tax environment for building and holding wealth for retirement, and during record low interest rates and an extended period of low growth, taking advantage of tax-effective structuring matters more than ever.
Investment returns are a big driver of final results, but so are taxes. Paying more tax than you have to eats into gross earnings and reduces what is left over for household cash needs or net capital. These lost earnings add up, particularly for long-term investment strategies.
Consider a $100,000 investment in an income-paying Listed Investment Company (LIC) on ASX, for example, BKI Investment Company Limited. Based on the past two dividends, the gross yield at 24 June 2016 is around 6.6 per cent. Gross income after allowing for franking credits of $6,600 would be reduced by almost $1,000 just from a 15 per cent difference in tax rates.
Another way to demonstrate the effect of different tax rates on investors is to consider the extra capital required to provide the same level of income. Again using BKI as an example, an investor with a zero per cent tax rate requiring $10,000 to help with annual living expenses needs to hold an investment of about $150,000. Whereas an investor paying 15 per cent tax wanting the $10,000 would need to hold an investment of just under $180,000.
Current tax rates within super
Before retirement, assets that are building inside super are held in what is called the accumulation phase, during which earnings generated are taxed at 15 per cent, whereas capital gains arising from the sale of an investment held for at least 12 months are taxed at 10 per cent. This compares to the pension or retirement phase, where current rules are that earnings and capital gains are tax free.
Although the super changes proposed for 1 July 2017 will limit how much you can hold in the tax-free pension phase, there is still plenty of room for most people to grow a very strong super balance for retirement.
The way super is taxed works beautifully for companies that offer fully franked dividends, too. Even in the accumulation phase, around half the franking credit will be paid back into the super fund, assuming there is no other assessable income within the super fund.
For workers who may face personal marginal tax rates of 34.5, 39 or 49 per cent, holding wealth in the accumulation phase of super will still be very attractive, provided they do not need access to the funds until retirement.
How an SMSF tax is calculated when multiple accounts are in place
Although most self-managed super funds (SMSF) operate a joint portfolio within the SMSF (called an unsegregated fund), it is very common for retirees and pre-retirees to have multiple accounts within the same SMSF. When these multiple accounts are in place within an SMSF, an actuary calculates how much of the SMSF is eligible for tax-free status and how much is taxed at the accumulation rate, and assigns a tax rate based on these proportions.
For example, if 50 per cent of an SMSF was in pension phase for the financial year and the remaining 50 per cent was in accumulation phase, the tax rate applied to the entire SMSF would be about 7.5 per cent.
SMSF trustees have the option to separate (or segregate) the assets that fund individual accounts within the SMSF. As a result of the proposed July 2017 changes to super, the interest in segregations has increased. Although the potential advantages can be to improve tax management of the SMSF and account for members with different risk profiles, segregation can be expensive as it requires administration and accounting work to be duplicated, and the benefits can be hard to realise in practice.
Although the pension phase – an entirely tax-free environment – might seem like an obvious preference to hold every investment, not everyone will have the choice to access this phase, because of age or the proposed changes imposing a maximum tax-free threshold.
Segregating assets within a SMSF requires trustees to assess which investments are more suited to the pension phase versus accumulation phase. Each account within the SMSF will then have its own investment portfolio and the exact tax rate for that phase of super will be applied to the earnings generated from that portfolio.
This compares to when the proportional tax rate is applied on joint SMSF portfolios (discussed above).
Trustees will need to consider a range of factors in making segregation decisions, such as the level of liquidity required in a pension account. This can mean segregating assets to a pension portfolio that are predominately growth-focused may not be practical.
For example, growth-focused investments such as the exchange-traded managed fund Magellan Global Equities Fund, which primarily invests in blue-chip global equities, may help investors to keep their portfolio growing over the long term. But as high dividend payments are not a focus of these investments, if they are held in pension phase they would need to be coupled with exposure to highly liquid investments.
This is just one example of why the practical implementation of segregation can be difficult. It can also be difficult to select the most predominant characteristic of an investment (i.e. growth or income) that proves to be accurate year after year.
In building and managing a portfolio in a SMSF, trustees must always have regard to their overall investment strategy principles, including cash flow requirements, diversification, inflation management and appetite for volatility. The mix of each will depend on the tolerance risk and personal needs of the individual investor and should be subject to annual review.