Basic retirement strategies change and evolve over the years so it’s not necessarily a good idea to assume the super arrangements you put in place more than three years ago are still appropriate and fit for the purpose.
A great example of the changing nature of super strategies is how to use the taxed and untaxed components of your super. For instance, these days you may like to structure these components to reduce the amount of tax your dependants pay upon your death.
You can control how much is in the taxed and untaxed components of your self-managed super fund (SMSF) in a number of ways, and one I’ll speak about next week is the multiple pension strategy. But first, let’s look at how these two components work.
Past strategies
Before Peter Costello’s Better Super changes, many people took money out of the super system as a lump sum and then contributed that money back into super as an un-deducted contribution (now called non-concessional contributions), then used all their super to commence a pension.
Given I’m talking about ancient history, I won’t go into details as to how this used to work, but quickly point out that these transactions were designed to increase the amount of tax-free pension income paid.
Another common strategy more than 15 years ago was to have more than one pension. Back then, rumours regularly swept through the financial services industry that the Government would imminently restrict access to lump sums from a pension. Investors purchased multiple pensions either to pre-empt any potential restrictions on taking a lump sum or to reduce over-exposure to one fund manager and their products.
The here and now
How relevant are these strategies under today’s legislative, political and market environment?
Taking money out of super and recontributing it back into super is still a good idea, but not necessarily because it reduces the amount of tax paid on annual pension income (although this may still be the case for those aged at least 55 but under 60 who are fully retired). Rather, it’s a good idea because of the reduced amount of tax payable in the event of your death.
Before Costello put his super changes in place, there were at least nine different components to super benefits and the value of some of these changed every day. Costello got rid of this mess and we now only have two components in super: the taxable and tax-free components.
Here’s how withdrawal and re-contribution works these days. The split between taxable and tax-free components of your pension is frozen in time when you commence a pension.
For example, suppose your pension commences with $600,000 of which $200,000 is a tax-free component. The $200,000 tax-free component is equal to 33.33% of the $600,000, meaning 33.33% of every payment – including all lump sums – from that pension will be tax-free.
Therefore, upon your death 66.66% of the account balance will be classed as a taxable component. These two percentages will remain the same for the life of this particular pension.
Tax on death benefits
Death benefits paid to non-dependants, such as your independent adult children, can only be lump sums and the taxable components of such death benefits are taxed at 16.5%.
Let’s assume for simplicity that at the time of your death, 66.66% of your pension amount is still equal to the $400,000 in the example above. The 16.5% tax on this would be $66,000.
($400,000 x 0.165 = $66,000)
If you took $100,000 out of your super before commencing your pension, but after your 60th birthday, then it would be paid to you tax-free. At this point, your tax-free component would fall to $166,666.
By contributing that amount back into super as a non-concessional contribution, you would increase the tax-free component to $266,667 or 44% of your total benefit. The taxable component would therefore become $333,333.
The tax payable on that portion of a lump sum non-dependant death benefit would fall to $55,000, or a saving of $11,000.
($333,333 x 0.165 = $55,000)
Some issues to consider
- Are you eligible to make super contributions?
- Where do you stand from a contribution cap perspective in the year you want to make the super contributions?
- What are the costs of completing these transactions?
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.
Also in the Switzer Super Report
- Peter Switzer: Beware of the negative experts [1]
- Paul Rickard: Shopping for the best rates on cash [2]
- Rudi Filapek-Vandyck: The broker wrap: BOQ, BLD and CCL [3]
- Lance Lai: Everything’s going according to plan [4]