Reconsidering recontributions

PORTFOLIO POINT: Tax-free super hasn’t entirely killed off the value of a recontribution strategy. Here’s how it can still make sense and why, if it’s in your armoury, you might want to fire it.

The brand of tax-free super introduced in July 2007 bought Australian super members significant joy. Turning 60 really did become a milestone birthday worth celebrating, as the majority were able to start drawing a super pension tax-free.

If they were already drawing a pension, then the ATO gave you a present of reducing the tax needing to be paid on that income stream to $0.

In the years leading up to that point, one particular strategy that had grown in popularity as a way of minimising – but not eliminating – the amount of tax to be paid on super pensions in retirement was a recontribution strategy.

It was a strategy that was used immediately prior to starting a super pension in retirement, as it could significantly reduce income tax. Little need for that if you’re over 60 and not going to pay any further tax on your income stream.

July 1, 2007, nearly killed it. But it didn’t quite.

Recontribution strategies are, as the name suggests, a way of taking money out of super and putting it back in. Why would you do that? As most things in superannuation tend to be, the reason is a straight tax play (although not necessarily done for your direct benefit).

The two main reasons to consider a recontribution strategy now are:

1. To reduce the tax payable on your super pension if you are under 60, and
2. To lower the tax ultimately payable to your beneficiaries in the event of your death.

Reducing tax 55- to 59-year olds

Whenever a complying super fund is turned into a pension fund, the fund itself ceases to pay tax. A super fund can make capital gains of $1 million a year after that, or rollickingly big income streams from previous investments and the fund itself will pay no tax in pension mode (where it used to pay 15% on income and 10% on capital gains).

However, that doesn’t mean that the income drawn from super is tax free.

Those eligible to draw income from their super fund, between age 55 and 59, receive a 15% tax offset on the portion of the income stream that is taxable.

The taxable component of a person’s super is the portion that has been concessionally taxed by the taxman previously – that is, concessional contributions. Largely, this is going to be Superannuation Guarantee payments and salary sacrifice sums. The component of your super that is tax-free – that is non-concessional contributions – will continue to pay no tax in pension mode.

Example: If we assume we’ve got a 55-year-old with $500,000 in super. Of that, $300,000 is concessional and $200,000 is non-concessional (that is, money that was contributed to super after all other tax was paid). If this pensioner were to take a super pension of $50,000 a year (the maximum 10% of his fund), $20,000 of that income would always be tax free. He would then get a 15% tax rebate on the remaining $30,000 of income that came from the fund.

Now, let’s put a recontribution strategy into effect. The low-rate tax cap for the 2010-11 financial year is $160,000.

All drawings must be proportionate to the balance. Our pensioner could withdraw up to $266,666 for recontribution and not pay any tax (60%, or $160,000 in concessional, with the remainder, 40%, as non-concessional).

The $266,666 of super would then go back into super as non-concessional contributions.

Table 1: Changing components in transition to retirement mode.

The tax-free proportion has now been lifted from 40% of the fund ($200,000 of $500,000) to 72% of the fund ($360,000 of $500,000).

For someone taking that 10% super fund pension, the amount on which some tax has to be paid has just fallen from 60% ($30,000) to 28% (or $14,000). For someone who would still be paying tax, the tax saving is $2400 each year for the five years until they turn 60, when it becomes tax-free.

Demolishing the death tax

Your ungrateful adult kids have sworn to put you in a home as soon as they get the chance. But they’re your flesh and blood and, no matter how painful they can be, you dislike the taxman more and still want to look after them financially.

If you are leaving your superannuation to a financial dependent, then all super will pass to them tax free. If you’ve got a wife, or kids under 18, then your super will pass in entirety, without the Tax Commissioner nicking some.

However, if you’re leaving super to non-dependents (because your partner pre-deceased you, for instance), then there is a defacto death tax in Australia.

If that’s the case, the tax-free portion still passes to them tax free. However, the taxable taxed portion will be taxed at 16.5% and the taxable untaxed portion (for example,  government defined benefit funds) could be taxed at 31.5%.

We’ll use the same numbers as above, but this time we’re using someone who is 63,has retired and has therefore hit a condition of release. (And we’ll assume there’s no taxable untaxed portion.)

While there is nothing to stop our 63-year-old taking the whole lot out tax-free, the problem is getting the money back INTO super. Those under 65 can put in up to $150,000 a year as a non-concessional contribution, or $450,000 in a year if they use the bring-forward provisions.

Table 2: Reducing death taxes

Had our pensioner died before the recontribution strategy was implemented, then 60% of the fund would have been taxed at 16.5%, leaving a tax bill of $49,500. Following the recontribution strategy, just $30,000 is left to be taxed, so a bill of $4950 is left. Their tax bill has been cut by 90%.

Recontribution strategies still make sense. They’re just of less value than they were previously because there is, overall, less tax being paid in super than there was previously.

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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 advised to consult your financial adviser.

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