More headaches for SMSFs

PORTFOLIO POINT: Halving the tax on interest earned outside super creates some more scales that need to be finely balanced for trustees.

If SMSF trustees watching last night’s budget felt another headache coming on, then you don’t need me to say that reaching for the painkillers would have done you no good. A second or third glass of wine stood a better chance of dulling the pain.

The Treasurer confirmed speculation that Australians will get a 50% reduction in the tax payable on earnings accrued through interest or coupon payments. It’s limited to $1000. The tax cut isn’t due to come in until July 1, 2011, and will apply to earnings from not just banks, building societies and credit unions, but will extend to earnings from bonds and annuities.

It’ll help the banks raise local deposits, the Treasurer said. It will create fairness for those who don’t benefit from the 50% reduction in capital gains that are currently in existence, he said.

Maybe. Colleague Robert Gottliebsen disagrees on the second point – he thinks it’s much easier for Australia’s banks to borrow overseas anyway.

The 50% capital gains tax (CGT) discount (or 33% discount for super funds) was designed by the previous government to to encourage investment – to reward investment risk. There is little to no risk in earning interest or coupons from government bonds. But let’s pass on the fairness and move on to how it will affect SMSFs and their trustees.

Simply, it will create a minor headache in chasing the best after-tax returns. And it has the potential to further complicate and distort superannuation (and can only create more work for financial advisers). How? Let’s assume interest rates on cash are 5%.  If you’re earning 5% interest on your savings and you’re earning $1000 interest, then you’ve got $20,000 in the bank (or in bonds or annuities, etc).

Now, do you hold that money inside or outside super?

If you hold it outside of super, you’ll now pay a maximum of 23.25% per annum (if you earn in excess of $180,000 a year). However, the vast majority of Australians will pay 15.75%, 7.5% or 0% on interest/coupons earned outside of super depending on their marginal tax rate. This will compare to 31.5%, 15% or 0%.

Hold that sum in super and you’ll pay either 15% or 0%, depending on whether your super fund is in pension phase, or not. (Complicated, of course, by where you might have the better deductions.)

Earning and taxing a quid:

1. Using Budget statistics that the real tax-free level for Australians has been raised to approximately $16k.
2. It could not be determined last night as to whether the 50% discount would be available to SMSFs, or not.

Further increases to official interest rates will reduce the sum on which it makes a difference. If interest rates rise to 7%, then we’ll be talking about a lump sum on which interest is being earned of $14,300.

It will also have an impact on those with mortgages. The best place for those with mortgages to have their cash holdings, from an earnings perspective, is usually in an offset account. And it largely still will be. But it will change the numbers a little.

Outside of this change – which was not specifically about SMSFs, but will impact on them – the changes “announced” in last night’s Budget were only those we’d heard 10 days ago in the Rudd Government’s response to Ken Henry’s Report.

1. The increase from age 70 to 75 for Superannuation Guarantee payments.
2. Raising the concessional contribution limit to $50,000 for those aged over 50, with less than $500,000 in their super fund.
3. A gradual increase in the Superannuation Guarantee levy from 9% to 12% by 2020.
4. The low-income earners’ $500 contribution tax payment, designed to wipe out contributions tax for those earning less than $37,000.

Far more interesting, in my opinion (and this was always bound to happen when I went on holidays), is what came out of Jeremy Cooper’s report recently.

Cooper has come up with his “10 Guiding Principles for SMSFs”.  They are largely sensible set, covering that trustees should bear ultimate responsibility, that they should have freedom from intervention, but not too much freedom, that they should be able to choose how many, if any, service providers they want to work with, consistency of law and compliance regimes, etc.

The one that sticks out a bit like a sore thumb, however, is “Principle 8”, which is the shortest one.

“Leverage should not be a core focus for SMSFs. While views will differ on this issue, the panel believes tthat there is room for leverage in SMSFs, but it should be ancillary to the main strategies employed to build retirement savings over the longer term.”

What does that mean? I simply won’t believe that a SMSF would take on debt to do anything other than build their retirement savings over the longer term.

If gearing is inappropriate for the trustees/members, then they are unlikely to take on that leverage. If it is appropriate for them – because they are younger, or have a considerable appetite for risk and understand those risks – then why not use it to “build retirement savings”.

It sounds like Cooper, or perhaps several of his board, wanted to ask the government to ban gearing in super, but couldn’t quite bring themselves to do it. Perhaps they felt reined in. See my column from March 17, 2010, where we discussed how Labor had confirmed super gearing was here to stay (and why, coincidentially, Cooper might have redrafted part of his SMSF gearing recommendation).

And there’s one more thing. Right near the end, at point 12.1, there was the one where Cooper’s panel said they wouldn’t pursue an “old fart’s” age-bias clause.

In December last year (click here for December 16, 2009)), we reported that Cooper had suggested he would consider recommending taking away a person’s right to run their own super fund beyond a certain age.

Ridiculous, which Cooper has admitted in the report. “Submissions were not supportive of restricting choice or control of SMSFs after members had reached a certain age. Understandable, because this challenges the ethos of SMSFs.”

Not to mention … exactly how long would the window be open for people to run their own super funds? Most people don’t open them until they’ve got a reasonably sum in there – which is inevitably later in life – and then you would have to close them because you were in vague danger of going senile?

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