One of the more common superannuation strategies is known as the ‘withdrawal and re-contribution strategy’. It can reduce the tax your adult children may pay on any super death benefit, and can also reduce tax payable if you are planning to retire early. With changes to the contribution caps and the ‘low rate cap’ for 2014/15, here is an update on how the strategy can be applied.
Superannuation benefit components
Before we get to the strategy, a quick recap on the components of a super benefit (lump sum or pension).
Superannuation benefits comprise two components – the ‘tax free’ component and the ‘taxable’ component. In a piece of ATO word-smithing brilliance, the ‘taxable component’ is further divided into a ‘taxed element’ and an ‘untaxed element’. The vast majority of superannuants don’t have to worry about an ‘untaxed element’ (as this will only occur if you were a member of a public sector scheme or some defined benefit schemes), so we will ignore this element for the remainder of this article.
The ‘tax free’ component represents the return of the non-concessional contributions you have made to your fund (i.e. your after-tax personal contributions), plus some other exempt components. When taken as a benefit (lump sum, pension, or death benefit), the component is always tax free.
The ‘taxable’ component represents the return of your concessional contributions, plus all the fund’s investment earnings. While there is no tax on the ‘taxable’ component if you are over 60, there is tax if you are under 60 and also for some recipients of a super death benefit payment.
The strategy
Most superannuants will have a much larger ‘taxable’ component’ than ‘tax free’ component.
When you start taking a super benefit, the amount of each component (‘tax free’ or ‘taxable’) is calculated by the trustees. This percentage is then fixed and stays with the benefit (e.g. a pension) for the life of the payment. For example, if you had $500,000 in super and the components were calculated as 20% ‘tax free’ and 80% ‘taxable’, a pension payment of $20,000 in the first year would have a ‘tax free’ component of $4,000 (20%) and a ‘taxable’ component of $16,000 (80%).
Instead of commencing a pension, by withdrawing an amount from super as a lump sum, and then re-contributing it back as a non-concessional contribution, the ratio between the ‘tax free’ and ‘taxable component’ is altered (it increases the amount of the ‘tax free’ component). This reduces any tax on a pension if aged under 60, and tax on a death benefit payable by an adult child.
Early retirement – meet Tom, age 56
Let’s look at an example. Suppose Tom, aged 56, is fully retired and has $1.5 million in super assets. Let’s assume that $150,000 is a ‘tax free’ component, and $1,350,000 is a ‘taxable component’.
If Tom took a pension, he would draw $60,000 a year based on a minimum payment of 4% per annum. Assuming Tom has no other income, the ‘taxable’ component of the pension of $54,000 (90% of $60,000) would be taxed $1,887, which is arrived at by taking income tax (including Medicare Levy and low Income Tax Offset) of $9,987 and subtracting a 15% tax offset of $8,100.
Tom could instead first reduce his tax by using the re-contribution strategy. Under current tax rules, you can take up to $185,000 of the taxable component out of your SMSF as a tax-free lump sum. This figure is called the ‘low rate cap’ and it is indexed each July 1.
As a withdrawal of a lump sum will be in the same proportion (10% ‘tax free’, 90% ‘taxable’), Tom withdraws $205,555, which comprises a ‘tax free’ component of $20,555, and a ‘taxable’ component of $185,000. Tom will not pay any tax.
A short time later, Tom contributes the $205,555 back into his fund as a non-concessional contribution (in this case, he accesses the ‘bring forward rule’, which means he can make up to three years’ worth or $540,000 in one year). Because this contribution will count towards the ‘tax free’ component, his respective balances are now ‘tax free’ of $335,000 and ‘taxable’ of $1,165,000. He still has $1.5 million in assets, but 22.33% of his SMSF is now a ‘tax-free’ component while 77.67% is a ‘taxable’ component.
If he now took an account-based pension, then his pension of $60,000 would only be taxable up to $46,602 (77.67% of $60,000), meaning that his net tax will only be $334 (income tax of $7,324, less the tax offset of $6,990). This represents a saving of $1,553. Over the next four financial years Tom will save $6,212 in tax.
For this strategy to work, it is essential to make sure that any contribution put into super is not subject to excess tax, which will apply if you aren’t eligible to make a non-concessional contribution greater than $180,000. If your super fund has to sell assets to pay you the benefit, make sure you factor in any capital gains tax payable by the super fund into your assessment of the strategy. Also make sure you factor into your costs any additional super fund administration costs or advice costs.
Avoiding super death benefits
There is another reason to withdraw a lump sum and re-contribute it back into super and that’s to reduce the amount of tax payable on death.
Any ‘taxable’ component of a super fund death benefit paid to non-dependants will be taxed at 17.0% (15.0% plus Medicare of 2.0%). Under an unusual legislative quirk, non-dependants include adult children (over 25 years, or over 18 years and not in full-time study).
Moving money from the taxable component to a tax-free component can reduce the tax your adult children will pay.
If we take the example of Tom above, we see that he now has 22.33% of his benefit as a ‘tax-free’ component. Once his pension starts, this percentage is locked in and doesn’t change. Suppose that when he dies, his pension account balance is worth $800,000. This means his tax-free component is $178,640.
When the death benefit of $800,000 is paid to his dependants, they will pay tax at 17% on $621,360. If he hadn’t executed the withdrawal and re-contribution strategy above, they would have paid tax at 17% on $720,000 (90% taxable component). Hence, the effective tax saving when the lump sum is now paid to the non-dependant is $16,769.
The ideal time to initiate the withdrawal and re-contribution transactions (in connection with death benefits to non-dependants) is when withdrawals from super are tax-free. That is, after age 60.
Critically, you need to be eligible to make the contribution, and if you are accessing the ‘bring forward rule’, you need to do this before you turn 65. Also, make sure that if your SMSF has to sell assets to make a benefit payment, you factor in any capital gains tax.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
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