SUMMARY: Paying off your home, or contributing more to super? Lower rates can make this an even more super idea.
Sustained low interest rates has certainly made paying off the mortgage easier in recent years. But it’s also given a boost to a combined super/mortgage strategy.
A question often asked by those in their 50s is: “Should they accelerate repaying the home loan, or direct spare funds to super?”
The answer is that you should usually do both. However, with interest rates as low as they are at the moment, it can pay to reduce your mortgage as little as possible and shovel as much as you can into super.
In essence, a strategy that would work for many Australians would be to switch home mortgage repayments to interest only. Then, salary sacrifice the savings from the reduced home loan payments into superannuation, meaning you are paying lower overall tax and getting more into super. Then, when you have turned 60 and can start to access your super tax free, access enough to pay out your home loan.
“Isn’t that just a nil sum game money merry-go-round?” No, it’s not. Let’s look at an example.
Let’s take a 50-year-old employee earning $100,000 a year. He’s got $120,000 left on his mortgage, at an interest rate of 5% (which is fairly standard now), which the remainder of a mortgage of $300,000 taken out 15 years ago.
Mortgage repayments are approximately $21,050 a year ($1754 a month) on principal and interest.
If the mortgage were switched now to interest only on $120,000, it would be $6000 a year. That has freed up $15,050 a year, after tax. Before tax, our 50-year-old had to earn $24,672 in order to finish up with $15,050.
If she were to now to salary sacrifice that $24,672 into super, it would only be taxed at 15% (rather than 39%), or $3700.80, leaving $20,971.20 to stay in the super fund.
Already, she has saved paying $5921 in tax – the difference between her marginal tax rate of 39% and the super contributions tax of 15% – which is in her super fund earning for her.
What extra do you have in your super fund after 10 years of implementing this strategy? I’ll make an assumption on investment returns of a flat 7% and will reduce earnings in the fund by an average tax rate of 12% (though trustees of SMSFs have a little more control over their tax than those in regular super funds).
Her super fund now has nearly an extra $300,000 in it. Having just turned 60 and retired, she can draw the $120,000 extra to repay the outstanding home mortgage. She still has an extra $180,000 in super.
However, we further need to reduce that $180,000 by the fact that there would have been savings for the mortgage having been paid down. But it would still leave somewhere north of $165,000.
This strategy makes far more sense when interest rates are low. It would also be significantly improved during periods when investment returns are higher (as they have been in recent years). But to take that out, I have used 7%, which should be a longer-term return for, say, a balanced fund.
Obviously, if investment markets are falling, then this strategy can struggle to make sense, but that is also why I have used a 10-year time frame.
How is this extra money magically created? It’s partly to do with the lower taxation of the salary sacrifice into your super.
Over 10 years – assuming only CPI increases in salary – there is nearly $60,000 of money that would have otherwise been paid in tax sitting in the super fund. That money will have been earning at a compound rate and taxed at super tax rates of 10 or 15%.
There are the extra contributions to super, which are invested in a low-tax environment.
And there’s the higher return. Paying down the home loan earns you 5%, a rate which is historical lows. Superannuation over the longer term should earn you more than that and I’ve used 7% in this example (though in the last two years, it has been significantly higher). During periods of higher home loan interest rates, the figures quickly reduce the effectiveness of this strategy.
There is a real sweet spot for this strategy – and it’s for those earning between about $100,000 to $160,000, where they have the ability to make considerable additional contributions to super.
Those earning more than $180,000 can still benefit, but it gets a little harder, partly because your super contributions from your employer are higher. If you’re earning $200,000 a year and your employer is putting in the 9.5% superannuation guarantee payment, then you already have $19,000 going into super, with a maximum of $16,000 you could contribute through salary sacrifice.
In general, the lift in the current concessional limit to $35,000, which came into force for the over-50s from 1 July this year, has meant this strategy has become far more appealing again. (The concessional contribution limit is only $30,000 for the under-50s.)
But it won’t work well for everyone. It works best for those in middle income brackets. Here, the tax saving from salary sacrificing is still significant enough to make the strategy work.
The move in recent years to lift the bottom tax rate from 30% to 32.5% has meant that the strategy works a little better than it use to for lower income earners also.
If the strategy appeals to you, get professional advice to help fine tune the strategy to make the most of your situation.
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.