(03) 9020 2905PORTFOLIO POINT: Here’s another super salary sacrifice strategy touted to help pay off your home loan faster. If you can tick the boxes, it could save you a $10,000 to $30,000.
Everybody loves paying less tax. And falling marginal tax rates – as most people just received again on July 1 – is generally appreciated. Even if it was only one cent in the dollar.
But one of the few disappointments about falling marginal tax rates is that some tax strategies become less and less advantageous. Negative gearing strategies, for example, are falling in appeal for those on the mid-to-high tax bracket of 38.5% (which operates between $80k and $180k), including the Medicare Levy.
The same can go for many superannuation and salary sacrifice strategies.
There’s one that several large fund managers/investment houses were recommending to people around the age of 50 who still have a mortgage. It’s a strategy I used to notice being pushed a few years ago, but haven’t seen promoted much in the last year or two.
The basic concept is salary sacrificing to super to help you pay your home loan sooner.
There are about three stages to the plan:
- You drop your mortgage repayments from principal and interest to interest only.
- The saving from not paying principal is then salary sacrificed to super at a grossed up rate.
- When you turn 60 and can access your super tax-free, you make a withdrawal to pay out (or down) your home loan.
And, so the theory goes, you get to keep the earnings in super for free.
There’s a pretty clear reason why we haven’t been hearing much about this one in recent years. Any strategy that saw you pumping money into super to buy falling assets through 2008, in order to pay off your home loan later, is unlikely to have worked too well over that period.
However, plans like this are not ones that should be taken over a short time frame. Paying off a home loan is a years-long process and this strategy is no different. We’ll be talking about it as a 10-year plan. Anything more than about seven years could be suitable to make it work.
With the help of a trusty Excel spreadsheet, I’ve modelled the strategy under the following scenario.
- Our super investor is 50
- Earns $100,000 a year
- Has 9% Superannuation Guarantee paid into super fund
- Has $120,000 left on the mortgage
- The mortgage has 10 years left to run
- The mortgage interest rate is 7% (and will average that over our 10-year period)
- The return on investments inside super is 7.2% (after tax, fees and charges)
The base case model
The home buyer’s choice is this: He can continue to make principal and interest repayments of $16,719.20 a year for the next ten years and will have his house paid off, or he can reduce his repayments to interest only of $8400 a year and salary sacrifice the remainder into super.
The difference between the two is $8319.20. However, that’s an after tax figure. If you gross that up to make it a before tax figure, our worker would salary sacrifice a total of $13,528 a year. After contributions tax, this would leave $11,499 going into the employee’s super fund.
After 10 years, given a 7.2% growth rate, the employee’s super balance from salary sacrifice and earnings, would have grown to $166,153. Our employee is now 60 and can access a super lump sum tax free, even if they haven’t retired or met another condition of release.
If you take off the difference in interest costs from converting to interest only from P&I, the employee would be able to pay out the $120,000 home loan and would have approximately $9349 in “profit” from the strategy. A little less than $1000 a year.
Permutations from there …
Things get interesting from there for our base case investor, when you start playing around with the growth figures. (I’m not going to play around with interest rates, as this strategy, by necessity, needs to be about 10 years long.)
I stress that the returns I use in this article are on an after tax, fees and charges basis – what a tax-paying accumulation fund gets to keep.
If the return is increased to 8.2%, the net sum left after repayment of the mortgage (and subtracting the interest that would have been paid anyway), puts you approximately $18,257 ahead.
A 9.5% investment return would leave you $30,617 ahead and an 11% return would create a windfall of $46,052.
If the return from the portfolio is only 5% over the 10 year period, the employee would actually fall short of being able to cover the $120,000 mortgage by about $8560. The break-even point is, from trial and error, a return of approximately 6.085%.
If markets only return inflation of 3%, the strategy would have cost the employee approximately $23,000.
Other tax brackets
Interestingly, the strategy works best for those who are on between $90,000 and $160,000 a year.
If you are an employee and earn well north of $180,000 and into the top tax bracket, then you become restricted by how much you can salary sacrifice into super over the 10-year term. That is, if you earn $200,000 a year, you are already having $18,000 put into super for you by your employer. While those over 50 have two years left of $50,000 concessional contribution levels, the ability to make much use of this strategy beyond mid 2012 will be limited (unless there’s a change of heart from a government).
The strategy doesn’t work so well for those earning below $80,000 either, as they don’t get the same marginal tax rate advantage of putting money into super. It doesn’t mean they won’t or can’t benefit, but the growth rates need to become, let’s say, heroic, in order for the potential benefits to outweigh the risks.
For someone earning $80,000 or below, the 7.2% net return would result in a 10-year loss of $7630. A return of approximately 8.15% would be needed to scrape even.
A return of 9.5% would return $11,465, while an 11% return would be $25,322.
Some of the figures I’ve seen used by some investment houses are assuming returns of approximately 9.5%, if you take into account fully grossed up franked dividends on the entire investment portfolio. So that assumes 100% investment in Australian shares. In order for it to work, it would also need to be net of fees, meaning you would need to add another 1 to 1.5% on top to cover them.
Okay for some, but not for everyone. This strategy, unusually, has a fairly defined set of potential clients that it leans towards. Those earning good money, but not too much, with an inclination towards taking larger risks inside super (that is, investing more heavily in shares and property).
*****
Reports in the financial media last week stated that the Australian Taxation Office is going to double the number of audits they conduct of self-managed super funds. That in itself is nothing to be concerned about.
However, it’s the change of focus that is a concern. The ATO has signalled that it is going to shift focus from educating SMSF trustees to enforcement. That means no more Mr Nice Guy.
If you make errors now, you are far more likely to receive a fine than a warning. And potentially have your SMSF made non-compliant, which is the biggest threat of all, as the ATO can fine your fund up to 46.5% of the fund’s contents. That’s not profit, that’s just a grab of nearly half of your super fund.
In total, about 185 funds were made non-compliant last year, up from 12 in 2006. And about 94 trustees were disqualified last year 27 four years ago.
Consistently, the biggest problems come from SMSFs making illegal loans to related parties and breaching the in-house assets test.
The ATO’s campaign will still be heavily targetted at those funds and trustees who they see are consistently making these errors or flouting these rules. Trustees need to continue to be diligent.
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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 this, you are advised to consult your financial adviser.
Bruce Brammall is director of Castellan Financial Consulting and author of Debt Man Walking.