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SUMMARY: Understanding SMSF tax … and then the tax saving that segregating pension assets might give you from 1 July.
Tax and access – at its most basic, these are the two things that differentiate investing inside, and outside, superannuation.
With super, you have “restricted access”, which means you can’t draw on your super until you meet a condition of release. For most, this will be 65. But it can be 60 (or even as young as 55).
But to understand the true power of super, you need to understand superannuation tax. And, for those who do have a good grasp, you need to understand how things will change in relation to tax from July 2017.
Superannuation tax – the basics
When you earn money outside of super, you pay tax at your marginal tax rate. This ranges from 0% to an effective rate of 49%, which kicks in once you earn more than $180,000 a year.
Superannuation, however, is taxed “concessionally”. This means that, in a general sense, it is taxed less than if you had the same investments outside of super.
(Note: However, this is the theory, but this isn’t completely true. Low-income earners often pay more tax on their super fund earnings than they would if they held the investment in their personal name.)
Superannuation is taxed at no more than 15%, to encourage people to put money away for their super. Unless you’ve been very naughty. If you’ve truly been bad, the ATO has the power to tax you at penalty tax rates, which are obscene.
The 15% maximum superannuation tax rate is for income to your super fund. This includes interest, coupons, distributions, contributions, rent and dividends, for example.
When you make a capital gain outside of super, half of the gain is ignored, with half added to your individual income. When a capital gain is made in super, one-third of the gain is ignored, with the remaining two-thirds taxed at 15% (This leads to an effective rate on capital gains for super funds of 10%).
And then there is the tax position of pension funds.
Tax on pension funds
Pension funds are not taxed. Not on income. Not on capital gains.
Pension funds are turned on when members turn a certain age (generally 55, 60 or 65) and request to take an income stream from their superannuation. This turns a superannuation fund into a pension fund.
At that point, the pension fund stops paying tax.
A fund could sell an investment property, or large parcel of shares, for a gain of $200,000. No tax to pay. The could take a massive punt on the overnight movement of a foreign exchange market and make $1 million. No tax to pay.
Or they could slowly, and surely, make the steady returns they have always made. If they are in pension mode, there is no tax to pay on any money earned by assets backing the pension fund.
Franked dividends
If you’ve every heard that super funds (particularly self-managed super funds, or SMSFs) chase fully franked dividends, but not understood why, here’s the explanation.
Let’s take a dividend from a major Australian company (say a major bank, or Telstra). The dividend is a fully franked dividend of $700.
A fully franked dividend of $700, really means gross income of $1000. The shareholder receives $700, with a franking credit attached, which accepts that $300 in tax has already been paid.
If you are in the “accumulation” phase of super, where your tax rate is 15% on income, you will get $150 back. Of a total of $1000, you have received $850 (equal to a tax rate of 15%).
If you are in pension phase for those shares, then you will receive the $700, but you will also receive the whole franking credit of $300 back in a tax refund from the ATO.
It is a different story for those who have earned the dividend outside of super in their personal names. For those earning less than $37,000 a year, they are likely to also get the entire $300 back. However, those who earn more than $37,000 will have to pay some extra tax on top of the $300. The top marginal rate will have to pay another $190 in tax.
What changes after 30 June?
Until 30 June 2017, the size of the pension fund hasn’t mattered. You could have a pension fund with $5 million or $10 million in it and whatever that pension fund earned would be tax free.
However, from 1 July 2017, those with more than $1.6 million in their pension fund are going to have to bring parts of that back to superannuation/accumulation.
That is, super fund members will be allowed to keep $1.6 million in pension – where it will never pay any tax. But if you have more than that, the excess will revert back to superannuation, where it will pay tax at superannuation (rather than pension) rates.
Obviously, for those with larger pension funds, this is going to mean extra tax will be paid on the amount transferred back to accumulation.
The big, approaching, choice
SMSFs have always had a choice as to accounting methods – unsegregated or segregated – when it comes to determining the tax position of their SMSF, which is partly in pension and partly in accumulation.The unsegregated method means that all assets of all members of the fund are treated as one pot (that is being added to and withdrawn from), with an actuary deciding which percentage of all of the assets becomes tax-free as part of the pension (that is, the portion of the fund that is in pension phase, and is therefore exempt current pension income).
The segregated method means that the trustees have made a declaration (backed by minutes) as to which specific assets have been segregated into the pension fund. And then those assets backing the pension fund are tax free, while the remaining assets of the super fund will be taxed at super fund tax rates.
Until now, most trustees (or their accountants) have opted to use the unsegregated method, as this is easier from an administration perspective.
But the segregated method is something that more and more trustees are going to want to put some thought into, as the tax savings could be considerable, with the limit on the pension as being $1.6m.
If trustees are only going to leave $1.6m in their pension fund, then choosing which assets stay in pension (or which assets are moved to pension, for those who will start them in the future) might lead to considerably better tax outcomes than just using the unsegregated, or proportionate, method.
Here are two examples (though I will deal with this in more detail in the coming months).
- You have a large capital gain on some shares/property. Say you bought the asset for $50,000 and it/they are now worth $500,000. You may wish to segregate this asset into the pension fund to avoid paying any portion in CGT upon sale. (You would also not pay tax on any income.)
- High yielding assets. If you put the high-yielding assets into the pension fund, then the income won’t be taxed.
Ultimately, this will be a decision that needs to be made by the trustee, potentially at the prompting of the accountant or financial adviser, who is also assessing various aspects of the portfolio.
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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 managing director of Bruce Brammall Financial. E: bruce@brucebrammallfinancial.com.au . Bruce’s new book, Mortgages Made Easy, is available now.