Busting the super reforms myths

PORTFOLIO POINT: Let’s bust a few myths about the real losers of last week’s high-end super tax grab.

One week out from the new changes to super and the uncertainty as to how everything will really work is no less confusing.

There are way too many questions that need to be answered. For that, we’re going to have to wait to see some legislation and let the propeller-heads work their way through exactly what means what.

Already, it’s clear there are a few myths that need to be busted open. Some I will do today.

But another thing is also clear. We probably have to assume that it’s going to go ahead. For all the lip we heard from some Labor MPs who threatened to cross the floor, including Simon Crean and Senator Kim Carr, it seems likely the changes will pass.

Crean said he would consider crossing the floor for any legislation that taxed super funds retrospectively. This is retrospective taxation, make no doubt about it. But Crean has already given his seal of approval. So we need to assume that it will become law.

How is this retrospective taxation? For 30 or more years, people have been able to put money into superannuation with the understanding that their pension fund account would not be taxed. People have made decisions based on that understanding.

The new laws – which will tax super pension accounts that earn more than $100,000 a  year in income – mean that some decisions that were made 30 years ago, or as little as one week ago, were made based on that assumption.

Importantly, we should also note that the Opposition hasn’t said they will dismantle these rules. They’re sticking to their previous policy of “no new negative changes to super in the first year or term”. That doesn’t mean dismantling anything.

As I will explain below, my main concern about the new tax is who it will punish. (I will return to measures include the new concessional contribution limits of $35,000 in future columns.)

When the Eurozone handed down the sentence on Cypress – that bank depositors were going to be “taxed” on their savings – I was actually shocked.

Not because of the punishment, but because of who was being punished. Those people who had their money in banks – traditionally the lowest risk asset class – were going to cop one in the neck for the country.

Investors in high-risk assets were, by default, being rewarded. Particularly if they had been lucky enough to pull money out of the bank and punt in on the stock exchange, they escaped a penalty.

Risk and reward are related. You want higher rewards, you chase the higher risks. If you’re interested in safety, you accept the lower risk that comes with investments such as bank deposits. But then the Cypress government comes in and taxes 10% of your savings. (You literally would have been better off putting it under the mattress.)

It’s not dissimilar to the risk versus reward conundrum that has just been created in super in Australia, with the new tax on super pension funds announced last week.

But one thing that needs to be understood by the SMSF community. The rules apply to each member, not to a fund. If you have two members of your SMSF, then each member gets the income limit of $100,000. A fund with four members could, therefore, have $400,000 worth of tax being earned before it is taxed at 15% on the excess, though distribution of income in a SMSF is never likely to be that even.

However, don’t for a minute believe this line pushed out that “it’s really only those with $2 million or more in super that are going to be affected”. That’s simply not right. It’s a broad brush figure, a throwaway line for a press release, that seriously obfuscates who is going to get hit.

There will be thousands of SMSF pension funds who have closer to $1.2 million that are going to be hit by the new tax. Further down, I’ll show you how SMSFs with just $500,000 could be hit.

And, conversely, there will be plenty of people sitting on funds of more than $3 million who won’t pay the tax at all.

This WILL impact on the way SMSFs invest.

Let’s debunk some myths.

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Myth #1 – that only funds with more than $2 million will be affected

Rubbish. There will be plenty of Eureka Report readers with less than $1.5 million in super who get slugged.

Why? Because the new tax on earnings of more than $100,000 is an income tax.

If you have super fund assets worth $1.5 million on which you’ve managed to receive a 7% return, then your super fund has earned $105,000 for the year. And you’re paying the new tax.

Please remember that it is per member, not per fund.

If you have $1.3 million in super and you’ve managed to earn an 8% income return for your super fund, the income is $104,000. And you’re paying the tax also.

Who gets returns like these?

Investors in the major banks and Telstra, on average, earn grossed up dividends of about 8%. Have a look at the following table, which takes the dividends of the four major banks and grosses them up to reflect the tax credits in the dividends. The final column then shows – if your super fund were made up entirely of that one stock – how little you would need to have of that stock in order to be impacted by the new tax.

All are below $1.34 million.

(Obviously, not for a second, do I suggest that SMSFs hold one stock as their portfolio.)

Table 1: SMSF favourites and income generation

But it’s not just high-yielding shares. There are thousands of SMSFs who switched to cash in early 2008, as the GFC was unfolding, and locked in long term deposits north of 8%.

Term deposits like that aren’t available now. You’ll struggle to get 4.5% today.

But less than two years ago, it wasn’t difficult to put together a fixed interest portfolio that yielded more than 8% income.

The 10-year average income distribution from the Vanguard Property Securities Index Fund is 7.81%. (There has been negative growth in that time.)

Myth #2 – that if you have $2 million in super, you will be affected

Not necessarily.

It will be quite manageable – depending on your attitude to taking a risk within your super – to have a super fund that is worth $3 million or more and not be hit by this new tax.

Investment returns are made up of income and growth. If you are more interested in chasing growth than income, you can potentially have a much greater amount of money in your super. There are plenty of small cap companies who pay no dividends, but who hold out the prospect of capital growth.

Take for example a super fund that is yielding just 3%. Arguably they are taking higher risk in their portfolio than someone who is taking a higher income portfolio. But that fund could be worth $3.33 million before it will be paying the new tax.

Myth #3: Capital gains aren’t income

Um, yes they are. Capital gains are income – they’re just taxed a different way.

There is still too much detail that is yet to be finalised, but let’s say your SMSF makes a profit of $50,000 on the sale of an asset. (Sometimes you have to take a profit.)

Presumably the one-third discount applies (for owning the asset for longer than one year) and you’ve got a gain of $33,333.

Now your super fund can only earn $66,667 from other assets before being hit by the tax. If they were getting an average return on their assets of 7%, then our super fund could be just $953,000 big before being hit by the new tax.

As super fund members get old, selling down assets becomes more and more likely. If you have to take profits, then you will be generating capital gains income that becomes, potentially, taxable.

Myth #4: Gloss comes off geared property investment. Or does it?

Property poses an even bigger problem. Take this to a not-ridiculous extreme and you could have a $500,000 SMSF being hit by the new tax.

Any property that is sold for a $150,000 gain looks likely to become subject to the new tax. Super funds get a one-third discount for capital gains. Apply that discount to a $150,000 capital gain and you’ve got $100,000.

Then, if your super fund pension account is earning anything else from the other assets it holds, that pushes its income over $100,000, then it will be paying tax at 15% on the extra income.

A super fund could be, literally, worth $500,000 to $700,000 and get stung.

There will be a couple of consequences for geared property investment.

For some, it will become less appealing. For others, it will become more attractive. If either is taken it up, it will distort the market.

Less appealing? The previous rules said that you could gear a property during your accumulation phase, then sell the property tax-free when you moved to a pension.

Not anymore. You might get away with it tax-free, but given the size of property and the profits it tends to generate, that’s highly unlikely.

But it also has the potential to distort on the other side of the ledger. If you have $200,000 worth of income in your super fund, then under the new rules, you would be up for $15,000 on the second $100,000.

However, what if your SMSF also had four investment properties, all negatively geared to an average of $25,000 each? All of a sudden your $200,000 income has been reduced to $100,000. And the size of your super fund may well have doubled from $2 million to $4 million.

Strategies to come

The new rules will throw up dozens of new strategies over the next few years.

Probably the most crucial will be splitting super with your spouse. There will be absolutely no point having one spouse with a $4 million and the other with nil.

As your fund approaches a combined income of $200,000 – even half way to that figure, it will require some super contribution management.

I’ll cover more in the coming weeks.

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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 extremely complex and require high-level technical compliance.

Bruce Brammall is director of Castellan Financial Consulting and the author of Debt Man Walking. E: bruce@castellanfinancial.com.au