Post-Budget pension advice issues

Strategies

Curtis Dowel
Wednesday 29 June 2016

The 2016 Federal Budget included a number of proposals that will impact the advice provided to clients. Of immediate impact were those related to contributions, which were outlined in the article Post-Budget super contribution advice issues.

The changes relating to pensions, while not requiring immediate action, may involve reassessment of the effectiveness of some clients’ pension strategies in the period prior to 30 June 2017.

The ‘pension cap’

If the proposals are enacted, the ‘pension cap’ will be initially set at $1.6 million

An effective limit on the amount of benefits that can be transferred into a tax free pension was proposed, to apply from 1 July 2017. If the proposals are enacted, the ‘pension cap’ will be initially set at $1.6 million. Where an individual has an existing pension balance at 1 July 2017 that is greater than this limit, or subsequently transfers amounts that exceed the cap, penalties may apply.

For many clients, any excess amounts over the pension cap will remain in accumulation phase to avoid the penalties. Those already in pension phase may elect to transfer any excess back to accumulation phase prior to 1 July 2017. Alternatively, the excess may be withdrawn from the super environment completely.

CPI indexation of the pension cap

The proposed pension cap is to be indexed to the Consumer Price Index (CPI) in $100,000 increments. Given that most superannuation thresholds are indexed to wage growth, it is likely that the indexation rate will be an issue raised during the consultation phase, if that eventuates.

CPI indexation will cause the pension cap to maintain its real value, but most superannuation funds will target a return rate that is higher than CPI. The potential impact on clients is best illustrated with an example.

Example 1:

Alice is 50 and has accumulated superannuation valued at $700,000. She earns $120,000 and only the compulsory superannuation guarantee (SG) payments are made on her behalf. Her fund earns 7.36% net of fees but before tax. Chart 1 shows how her balance quickly approaches (and exceeds) the indexed value of the pension cap. By age 65, her balance of $2,311,000 exceeds the indexed pension cap ($2,300,000), so she will begin to have an excess from this point.

Balances that initially may appear ‘safe’ from exceeding the pension cap, may therefore require longer term pension cap management strategies.

Pension cap management for a couple – spouse contribution splitting

While an individual has a single cap of $1.6 million, couples have the advantage of being able to target each individual’s cap, or $3.2 million in total. For couples, especially where one member earns significantly more than the other, it becomes important to have long term plans in place to target the ‘combined’ pension cap. This can reduce or eliminate the funds that exceed the pension cap.

Example 2:

Revisit Alice from Example 1. Assume Alice’s husband, Quentin, is the same age as Alice and has $150,000 in super and earns $40,000. Quentin’s employer also only contributes the required SG amount.

We know from our previous example that, based on our assumptions, Alice will exceed her pension cap by age 65. Quentin, on the other hand, is unlikely to breach the pension cap, as he has a relatively small balance with only modest contributions being made on his behalf.

Alice may choose to ‘spouse contribution split’ her SG contributions to Quentin each year. The maximum that can be split is 85 per cent of her concessional contributions for the year. If she does this each year until they cease working at age 65, her balance reduces from the previously projected $2,307,000 to $1,926,000, while Quentin’s balance increases from $540,000 to $921,000 (Chart 2). More importantly, Alice’s balance now does not exceed the indexed pension cap amount, so she will have no excess amount.

Chart 2: The impact of spouse contribution splitting

The amount that could be accumulated under their combined pension caps could be increased, if, for example, Alice were to contribute up to her concessional contributions cap and split 85 per cent to Quentin’s account each year.

Alternative tax structures

Those clients who are likely to exceed the pension cap may consider alternative tax structures.

Table 1 shows the effective rates of tax for various tax structures.

Table 1: Effective rates of tax

StructureTaxable incomeIncomeCapital gains (>12 months)
Personal* $180,000+ 47% 23.5%
Personal* $87,000# - $180,000 39% 19.5%
Personal* $37,000 - $87,000# 34.5% 17.25%
Accumulation phase 15% 10%
Pension phase 0% 0%
Corporate 30% 30%

*Rate includes Medicare levy, excludes temporary budget repair levy which will cease 30 June 2017

# proposed threshold effective from 1 July 2016

The effectiveness of each tax structure is determined by the after-tax returns generated. For example, income derived by a corporate entity is taxed at only 30%, which is less than the marginal rate for those whose income exceeds $37,000.

Contrast this with capital gains on assets held for more than 12 months, which receive no discount when incurred by a company, and therefore have an effective rate that is higher than capital gains realised by those on the highest marginal rate of tax.

The Budget proposals also included a reduction in the corporate tax rate progressively to 25% over a ten year period, making a corporate structure more attractive from a tax perspective if this measure does become law. However, withdrawing funds from a corporate entity may result in effective taxation at the recipient’s marginal tax rate, which may exceed the corporate tax rate.

Holding assets within accumulation phase is generally more tax efficient than taxation of income at personal marginal tax rates, with the exception of those individuals on the lowest marginal rate of tax.

So accumulating a superannuation balance which exceeds the proposed pension cap is still potentially a tax effective strategy, but the challenge is doing so with the tighter restrictions on making superannuation contributions that were announced in the Budget.

Tax structure strategy may vary for different asset levels

However, what are the options for those that have exceeded their cap? The immediate response may be for them to maximise the amount in the tax free pension phase, leaving the remainder in accumulation, but is this always the best strategy in the long term?

Let’s have a look at a number of scenarios, to see the impact of tax on each situation.

1. Low/moderate asset level at retirement

Example 3

Owen and Nina, both 65, have accumulated a combined $600,000 in superannuation. Both being well under the pension cap, they could each commence a tax free pension and draw a pension, also tax free, to meet their needs.

One effect of the current marginal tax rate system is that a significant amount of assets can be held in an individual’s name before any tax is paid on the returns generated, due to the tax-free threshold. In Owen and Nina’s case, if they were to withdraw the entire amount from super and invest it evenly between themselves, neither would pay any tax. As a result, their assets last for the same length of time as if they had continued to hold them within a pension, and two years longer than having held the assets in accumulation phase.

A recommendation to move assets from a tax free environment to a (potentially) taxable one may be an uncomfortable one for many advisers. On the surface, there is no advantage in doing so – the situation is the same both inside and outside of super.

A superannuation account based pension may be a convenient vehicle for both Owen and Nina, with regular, automatic pension payments and statutory reporting requirements. But all being equal, a superannuation fund is likely to have higher fees than an equivalent non-superannuation investment platform, so that convenience may come at a cost to Owen and Nina.

Furthermore, given recent history, many may consider the superannuation environment to carry greater legislative risk.

However, the non-superannuation option has one clear advantage – estate planning. Funds held outside super, when paid to any beneficiary are not subject to tax. Contrast this to benefits inside super when paid to tax non-dependants, where the taxable component is subject to tax at 15 per cent, plus Medicare (where applicable).

Taking our example further, let’s assume Nina survives Owen. Upon Owen’s death his benefits revert automatically to her, without any additional tax implications. Assume also that Nina subsequently passes away at age 87, leaving her benefits to their only child, Jacob (a tax non-dependant). If at her death, Nina has benefits of $216,000 comprising 90 per cent taxable component ($194,400), then Jacob will receive $181,980 net of tax and Medicare.

Contrast this to the non-super position, where Jacob will receive the whole $216,000 from her investment portfolio, $34,020 more than if receiving the benefits directly from super. Note that in the non-super scenario, Jacob will inherit the capital gains tax (CGT) cost bases from Nina and any accrued capital gains may be taxable upon realisation of those assets, decreasing the attraction of the non-super position.

2. $2.0 million of assets at retirement

Example 4

Let’s look now at the position of Eliot. He is also 65, has $2 million in super and requires income of $40,000 each year. We will assume he commences a pension up to the proposed cap of $1.6 million. This will require him to draw a total of $80,000 in pension payments, which is well above his needs. This excess will be invested personally, although he could reinvest in super via concessional and/or non-concessional contributions until his 75th birthday, if the Budget proposals are enacted.

The surplus pension income that he will invest in his personal name will not, initially, create a personal tax liability. So the fact that we have a leakage from the superannuation environment is not detrimental.

It is interesting to note that if the commencement value of Eliot’s pension is reduced to $1 million (and the remaining $1 million is kept in accumulation phase) to minimise this leakage, Eliot’s asset level is reduced significantly over time.

Having leakage in this scenario has a positive effect - the funds remaining in accumulation phase are taxed at 15 per cent, compared to the capital invested personally, which at the initial modest values, will not result in his income exceeding the tax free threshold.

The impact of tax on death benefits is also an issue for Eliot in this scenario. At his current life expectancy (age 84), his projected benefit under each scenario, and the net of death benefits tax, assuming his benefits are also 90% taxable component and paid to a tax non-dependant, are shown in Table 2.

Table 2: Impact of death benefits tax

$1.6m pension$1.0m pension
Pension $612,361 $579,954
Accumulation $927,926 $1,530,902
Non-super $724,725 $54,831
Benefits tax $235,664 $322,961
Net benefit $2,029,348 $1,842,726

The impact of death benefits tax is quite significant again. By commencing a larger pension and building a portfolio outside of super, Eliot could save his tax non-dependants over $186,000 in benefits tax (less the accrued capital gains on the non-super assets).

3. $6.0 million plus of assets at retirement

Example 5

In our final example, we will look at the position of Julianne, who has accumulated $3 million inside super and $3 million outside of super, as well as receiving rental income from her properties of $60,000 per annum. She requires $140,000 of income each year.

Julianne has the option of commencing a pension and drawing the minimum amount, or not commencing a pension at all, and drawing her living requirements from her non-super portfolio. The results of both of these strategies is shown in the chart below.

Initially, moving benefits into pension phase is beneficial, but over time this benefit decreases. This is as a result of money being paid out of the pension, its capital depleting over time and therefore the tax free benefits derived from the pension decreasing, while funds held outside of super increase, increasing the personal tax liability.

The opposite happens for the non-pension portfolio. Income needs are being met by withdrawals from the personal portfolio, which over time decreases, which also decreases the personal income liability. However, in this scenario, it is in the 26th year that the non-pension portfolio produces a better outcome compared to the pension portfolio. In Julianne’s case, she will be 90 at this point in time.

As we saw in example 3, the net of tax death benefits may be a factor for potential non-tax dependant beneficiaries.

An alternative for Julianne could be to use a corporate structure for her non-super investments. This could be via a family trust with a corporate beneficiary, a company or an insurance bond.

A possible strategy utilising a corporate structure is for Julianne to hold sufficient assets in her personal name so that she pays no tax herself, with any additional income being diverted into the appropriate corporate structure. In doing so, she can maximise her capital in the concessionally taxed superannuation environment, while also ensuring any returns on capital held outside of super are not taxed at more than the corporate rate until those returns are distributed from the corporate entity. But she would lose the benefit of the CGT discount for CGT assets held within the corporate environment.

Conclusion

The Budget proposals, while an initial shock for financial services professionals, can provide additional structuring opportunities for clients of all asset and income levels

The Budget proposals, while an initial shock for financial services professionals, can provide additional structuring opportunities for clients of all asset and income levels. In many cases, it may be beneficial to commence a pension up to the maximum available, be that an individual’s account balance or the pension cap. In other cases, investigation of alternative investment structures may be prudent, to bring the tax burden across all investments structures down.

In making these decisions, consideration should also be given as to whom the ultimate beneficiary of any death benefits may be, and the tax that may be incurred on any amounts paid from superannuation. The level of capital that may be held outside of super before tax is paid can be quite high, and these assets can be bequeathed to beneficiaries without the impact of superannuation death benefits tax.

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Appendix

AWOTE = 3.5%

CPI = 2.5%

Earnings rate = 7.36% after fees but before tax

Pension payments and contributions are assumed to occur halfway through the year

Income needs increase by AWOTE

Tax thresholds increase by AWOTE

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