In early April, the government revealed some of the superannuation changes it is looking to make. Daniel Butler and Tina Conitsiotis assess what the implications may be for SMSFs in pension phase.
The Labor government on 5 April announced a number changes to superannuation. The main change is the proposed new tax on pension earnings that exceed $100,000 per member per financial year.
Assuming the proposed changes do become law, they are likely to have a significant impact on certain super fund members. This article discusses the practical implications of the proposals with a focus on SMSFs.
How does it work?
Under the proposed changes, earnings on assets supporting pensions that exceed $100,000 per member per financial year will be taxed at 15 per cent. Earnings below this threshold will remain tax free. This change is anticipated to have effect from 1 July 2014. Importantly, the $100,000 threshold is proposed to:
- apply in respect of each member,
- be an annual limit reflective of taxable income as determined under existing tax rules, and
- be indexed to the consumer price index in $10,000 increments.
Example
Consider mum and dad, who each have $2 million in their SMSF (that is, $4 million in total). Both are receiving a pension and the SMSF is fully in pension mode. What are the implications if the SMSF generates a 5 per cent return and a 10 per cent return?
- Tax payable if the SMSF generates a 5 per cent return
- $200,000 of total pension earnings have been generated in the fund (that is, $4 million x 5% = $200,000).
- Remembering the $100,000 threshold relates to each member and not the fund as a whole, the $100,000 threshold has not been exceeded by either member and therefore, under the proposed new laws, the SMSF tax liability is nil.
- Tax payable if the SMSF generates a 10 per cent return
- $400,000 of total pension earnings have been generated in the fund (that is, $4 million x 10% = $400,000).
- There is a 15 per cent tax on earnings exceeding $100,000 for each member.
- Therefore, under the proposed new laws, the SMSF tax liability is $30,000 (that is, (($200,000 – $100,000) x 15%) x 2)./li>
Note, Prime Minister Julia Gillard made a commitment to the electorate well prior to the 5 April announcement that there would be no extra tax payable for members aged 60 or older. Interestingly, the proposal is to levy the new pension tax on super fund trustees.
Practical implications
Arbitrage opportunities
The new pension tax might create arbitrage opportunities, whereby investing outside of the super environment may prove more tax efficient for certain members. This is especially so as in recent years the concessions in super have attracted many people contributing most of their investable assets previously held outside of super into the super environment to take advantage of the pension exemption (both within and outside the super fund) when someone turns 60 and draws a pension.
Example
Consider retirees mum and dad who have a joint total of $4.75 million in their SMSF. Both are receiving a pension and the SMSF is fully in pension mode. They transfer $750,000 into a family trust. Both the SMSF and the trust generate a return of 5 per cent. The associated taxation implications are as follows:
Tax payable on the income generated from the trust. The trust generates earnings of $37,500 (that is, $750,000 x 5%). Assume this income is split equally between mum and dad.
Taking into account the tax-free threshold (which is $18,200 for the 2013 financial year), the total tax payable is: $209 (that is, $37,500 – ($18,200 x 2) x 19%).
The above ignores any tax rebates or offsets that might be applicable.
Tax payable at the SMSF level
The SMSF generates earnings of $200,000 (that is, $4 million x 5%). Assume these earnings are allocated equally between mum and dad.
Remembering that the $100,000 threshold relates to each member and not the fund as a whole, the $100,000 threshold has not been exceeded by either member and therefore, under the proposed new laws, the SMSF tax liability is nil.
Total tax payable: $209
Now consider the implications if mum and dad did not transfer the $750,000 into their trust.
Tax payable at the SMSF level
The SMSF generates earnings of $237,500 (that is, $4.75 million x 5%). Assume these earnings are allocated equally between mum and dad.
There is a 15 per cent tax on earnings exceeding $100,000 for each member.
Therefore, under the proposed new laws, the SMSF tax liability is $5625 (that is, (($118,750 – $100,000) x 15%) x 2).
Total tax payable: $5625
Thus, $5416 is saved by investing $750,000 via the trust. As you can see from the above example, people will be tempted to move assets outside of super to minimise their tax. This arbitrage opportunity is likely to see a significant shift of assets away from super, thereby undermining the amount that will be raised from this new tax.
Accumulation phase – more attractive?
In light of the proposed pension tax, the natural inclination for some might be to move away from pensions. The reason for this being that once pension earnings reach the $100,000 threshold, the tax treatment of a member holding an accumulation versus a pension interest inside super will broadly be the same. That is, both will be taxed at a maximum 15 per cent at the fund level (with a 10 per cent rate applicable to capital gains on assets held for more than 12 months). However, there can still be significant advantages to maintaining a pension.
Growth generated by a fund in pension phase will accrue in proportion to the tax-free and taxable components of the member’s interest, as at the date of the pension’s commencement. This is contrary to an interest in accumulation, where all growth will form part of the taxable component. Accordingly, one way to maximise the tax-free component of an interest is to keep it in pension phase. This might be a worthwhile strategy, despite the proposed new pension tax.
