Monday 29 August 2016
Shifting the advice focus to non-superannuation structures
A number of the 2016 Federal Budget announcements will, if enacted, result in a renewed focus by financial services professionals on utilising a client’s capacity to receive income tax-effectively in their personal name.
In the short term (prior to 1 July 2017), the proposed introduction of the $1.6 million pension cap will force many clients to consider how to structure funds in excess of the pension cap.
Over the longer term, the proposed restrictions on concessional and non-concessional superannuation contributions will mean some clients, including those many years from retirement, will have significantly less capacity to accumulate funds in superannuation, and will seek tax effective alternatives to superannuation.
...the proposed restrictions on concessional and non-concessional superannuation contributions will mean some clients, including those many years from retirement, will have significantly less capacity to accumulate funds in superannuation...
Furthermore the proposed removal of the anti-detriment provision may also trigger a re-think of whether a superannuation pension is the ideal long term retirement funding vehicle for those with low and moderate levels of retirement assets.
With these issues in mind, this article aims to highlight to financial services professionals the capacity of an individual to receive tax-effective income in their personal name.
The effective tax free threshold
The ‘headline’ marginal tax rates which apply to resident taxpayers are shown in Table 1 below. This table suggests that tax becomes payable when taxable income exceeds $18,200.
Table 1: Headline marginal tax rates – 2016/17 (proposed)
|Taxable income||Tax payable1 - residents|
|Up to $18,200||Nil|
|$18,201 - $37,000||Nil + 19%|
|$37,001 - $87,000||$3,572 + 32.5%|
|$87,001 - $180,000||$19,822 + 37%|
|Above $180,000||$54,232 + 47%2|
However, the effect of certain tax offsets is that individual taxpayers can receive more than $18,200 of taxable income without paying any personal income tax. For example, the low income tax offset (LITO) of $445 generally applies if taxable income is $37,000 or less. LITO causes the effective tax free threshold to increase to $20,542.
In addition, seniors and pensioners that meet certain eligibility criteria may also be eligible for the seniors and pensioners tax offset (SAPTO) of up to $2,230 for single persons and $1,602 for each member of a couple. The combined effect of SAPTO and LITO increases the effective tax free threshold to $32,279 (singles) or $28,974 (each member of a couple).
What does ‘effective marginal tax rate’ (EMTR) mean?
Beyond these effective tax free thresholds, tax becomes payable at the headline marginal rates shown in Table 1. In addition, the Medicare levy becomes payable from various thresholds, depending on family and seniority status. Furthermore, the tax offsets mentioned above begin to phase out at certain levels of taxable income, further reducing net income received.
To illustrate EMTRs, consider the amount of tax and Medicare that Jack (who is not a senior or a pensioner) pays on his taxable income of $25,000 – refer Table 2 below.
Table 2: Effective marginal tax rate at $25,000
|Jack’s present position||Add $100 taxable income||Difference|
|Total tax and Medicare||1,214||1,243||29|
Table 2 shows that an extra $100 of taxable income results in $71 after tax, so the effective rate of tax and Medicare on this $100 is 29 per cent (comprising marginal tax at 19 per cent and Medicare at 10 per cent).
Chart 1 shows Jack’s position ("red triangle") in the context of the EMTRs for non-seniors and pensioners with taxable income in the range $10,000 to $50,000.
EMTR of 56.5 per cent for the over 65s!
Generally clients who have reached age pension age (currently 65 years of age) are eligible for SAPTO, whether or not they are in receipt of the age pension. It is noted above that SAPTO raises the effective tax free threshold to $32,279 for singles and $28,974 for members of a couple, but it also has a significant impact on the EMTR above these thresholds.
Chart 2 shows that the EMTR for singles is 31.5 per cent from $32,279, but quickly increases to 41.5 per cent and ultimately to 56.5 per cent from $37,000. The 56.5 per cent EMTR is comprised of: headline marginal income tax at 32.5 per cent, LITO phase out at 1.5 per cent, SAPTO phase out at 12.5 per cent and Medicare levy phase in at 10.0 per cent.
Furthermore, the overall average rate of tax applicable to taxable income between $32,279 and $50,000 is in excess of 48 per cent ($8,532 of tax and Medicare is paid on $17,721 of taxable income).
The impact of imputation credits
Although technically this EMTR situation is unchanged by imputation credits attached to franked dividends, imputation credits may change a client’s perception of their effective tax free threshold.
A fully franked dividend of $100 equates to approximately $143 of taxable income when the imputation credits are added back, and a $43 refundable tax credit is available. So a single senior may receive $22,595 of fully franked dividends (which equates to $32,279 of taxable income) before their EMTR exceeds zero. If taxable income exceeds this level, income tax and/or Medicare will be payable, but will be offset by some (or all) of the taxpayer’s full entitlement to imputation credits, with only those imputation credits remaining being refunded to the taxpayer.
However, many clients may view their position from the perspective of the cash dividends they receive. In some cases they are un-phased by not receiving a full refund of their imputation credit entitlement and only consider they are paying tax when their tax and Medicare liability exceeds the level of imputation credits, hence effectively reducing the level of cash they receive. If receiving fully franked distributions, this point is reached at $96,200 of cash distributions received.
Chart 3 below shows the position of a single senior who receives cash distributions which are 60 per cent franked. Although the EMTR results are the same as shown in Chart 2 above (the level of distributions received before any tax is paid is $25,676, equating to taxable income of $32,279), the client will only be required to pay tax in excess of their imputation credits when distributions exceed $48,400. From this point the Net income after tax in Chart 3 is less than Distribution received.
EMTRs - opportunity or hazard?
The effective tax free threshold is both a planning opportunity and a hazard. The opportunity lies in utilising a client’s tax free threshold, but income in excess of that level is less tax effective in their personal name than if generated and taxed in the accumulation phase of superannuation (that is, generally subject to a maximum tax rate of 15 per cent).
The opportunity lies in utilising a client’s tax free threshold, but income in excess of that level is less tax effective in their personal name than if generated and taxed in the accumulation phase of superannuation
Assuming a balanced portfolio of $925,0003, approximately $32,279 of taxable income will be generated in year one. Portfolio growth will result in income exceeding the tax free threshold in year two and subsequent years. So, when compared with the superannuation accumulation phase alternative, the tax efficiency of the personal portfolio may reduce quickly in subsequent years.
Constraining taxable income within the effective tax free threshold is a challenge. Marginal tax rates, Medicare rates and thresholds, and tax offset entitlements may change with Government policy decisions, increasing or reducing the effective tax free threshold and EMTRs.
If tax and Medicare rates remain unchanged, a lower starting balance may allow for growth in taxable income in subsequent years, but consequently some of the tax free threshold will not be used (and hence wasted) in year one.
Ideally, taxable income in a client’s personal name would be maintained at a flat level over successive years, or as flat as possible. That may be achieved by selecting cash and fixed interest assets in a personal portfolio and weighting the growth portion of an overall portfolio exposure to superannuation pension and accumulation interests.
Further discussion of this strategy and related issues will be published in a later article.
Read more post-budget analysis below:
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