Super pension strategies

PORTFOLIO POINT: The benefits of having your SMSF in pension mode go way beyond finally taking a tax-advantaged income stream. It should influence how you invest.

Drawing a pension from your super fund is what super is all about – and it’s right there in the legislation, which states that super funds are there to “provide retirement benefits”.

To that end, you spend the better part of a lifetime building up the super fund part of your nest egg. And then comes time to start drawing on it.

But drawing a pension isn’t the end game. Starting a pension – and continuing to draw one – should involve tactics and strategy from the SMSF trustee.

Not all SMSF trustees who are drawing a pension (or are about to) give much thought to it, beyond taking the income stream. But you should, to take advantage of how you can advance your super fund’s overall wealth.

So in today’s first part on pension fund benefits, let’s start by opening your mind to the not-so-obvious benefits of starting your SMSF’s pension.

The basics: When can you turn on the pension?

For a start, you have to be of a particular age. Your preservation age is determined by your birthdate.

Table 1: Preservation age

Generally, you need to have retired in order to get access to your super. However, changes in the last decade mean that you can take a “transition to retirement” pension from your preservation age (above).

Why take a pension?

Superannuation is designed to be a low-tax vehicle throughout its life. To that end, money put into super is usually taxed at no more than 15% on the way into the fund (although there are exceptions for breaching your limits, click here (6/4/11)). And superannuation is low-tax (potentially no-tax) on the way out also.

If you access super prior to age 60, the payments are considered to be income and is taxed. However, a 15% rebate is attached. So, the maximum tax rate will be 31.5%, but is potentially tax free.

And once you turn 60, it is tax-free.

Many people claim they don’t want to take a pension from age 55, because they’re “not ready to retire”. If that’s you, please read this column (December 8, 2010) to understand why taking a “transition to retirement” pension from super actually has little to do with retirement. It’s about tax … and paying less of it.

How about your super pension fund and income tax?

So if the income you draw from your super fund is tax-advantaged, what about the pension itself?

Well, here’s the real point of today’s column. Turning on a super pension is where the real fun, and tactics, need to begin. While in accumulation phase, the super fund itself pays tax at 15% on income and 10% on capital gains.

But a pension fund pays no tax. That’s right – none. No tax on capital gains. No tax on income. No tax at all for those assets held in the pension fund.

For example, if you are earning 6% interest from your SMSF bank account on cash of $400,000, then your super fund would be earning $24,000 in interest and would lose $3600 of that in tax. In pension phase, $0.

If you had $600,000 of Australian shares earning fully franked dividends of 3.5%, you would receive $21,000. The associated franking credits would be worth $9000. A fund in accumulation phase would get back ($4500) half of those franking credits, being the difference between the 30% company tax rate in Australia and the 15% income tax rate of a super fund. However, if those assets are in your pension super fund, you get back the whole $9000.

Every year.

And capital gains …?

Ditto. Any capital gains made on assets that are in pension phase will not be subject to capital gains. You could make a $1 million gain on an asset and you’ll pay no tax, if the asset was owned by the pension fund at the time of the sale.

Even if you owned the asset for 20 years, if you turn on a pension and that asset is in the pension fund, then no tax will be paid on it.

(This is one of the main reasons Treasury Secretary Ken Henry is so concerned about gearing in super. If SMSFs gear up (click here, 20/10/2010) and pay no tax in accumulation phase, they can then also escape paying tax in pension phase. But that’s the current rules.)

Should I have more than one strategy?

Absolutely. Given the rules are different between accumulation and pension, your super fund should consider having different strategies for pension and accumulation funds. Many people, particularly those on a transition to retirement pension, will actually be running two funds for an extended period of time. That is, you’ll have a pension fund, but as you’re still working, your 9% employer contributions and your own salary sacrifice amounts will be going into your accumulation fund.

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So, what strategies are important then? I’ll just cover some basic ones now and we might expand on these in the coming weeks.

Don’t cash in until the pension has started

One of the most obvious strategies is to hold off on selling assets with large gains until they have been transferred into a pension fund. Huge potential capital gains can be neutralised if the asset is sold the day after the pension is begun.

Many SMSFs could be sitting on gains of tens of thousands of dollars if they’ve held BHP shares for a decade or more, or held investment property for a similar period. Make this tax zero by selling after assets are transferred to pension.

Certain income tax versus possible capital gains tax

With all investing, one of the downsides of taking the certainty of income (interest, coupons, dividends) is that tax needs to be paid. You pay tax on income at 15% in accumulation phase. When it comes to capital gains, not only do you pay it at a lower rate (10%), but if you never sell, you never have to pay CGT.

Simply, in accumulation, there is an advantage to opt for capital gains because they are taxed at a lower rate (10% versus 15%) and may never be taxed anyway. Conversely, in a pension fund, the appeal of NOT having income taxed at a higher rate is going to have more appeal.

If interest rates rise further, you might be happy to take the 6-7% tax-free interest rate in your pension fund, but wish to continue to take higher risks with the money sitting in your accumulation account, because gains are only taxed at 10% only if they’re ever sold.

Trade away

Trading shares inside a SMSF – buying and selling inside a year – would be treated as income and would be taxed at the higher rate of 15% when in accumulation. But if the fund is no longer paying tax, then taking short-term gains is no longer a concern.

Even buy and hold investors should see some temptation in taking short-term gains, if prices have risen to levels that are beyond where you would see as valuable. Not taking quick, easy, gains because you don’t want to pay the CGT is not an excuse that applies to pension funds, though it can often cripple investors.

Next week, we’ll continue delving a little deeper into pension fund strategies.

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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.