The changes to super announced in last year’s federal budget are almost upon us. And while many Australians will not be significantly affected, SMSFs and individuals with larger super balances are likely to feel the negative effects from 1 July.
Let’s look at what, if anything, SMSFs can do to offset their losses. There are other, tax-effective ways of investing outside of super – it’s simply a question of weighing up the pros and cons.
There’s been a lot of talk about the consequences of the recent changes to super, not least because they may not be the last. According to recent commentary in the Australian Financial Review, SMSFs with loan amounts as part of their strategy may be next. That’s if a government proposal aimed at stopping these SMSFs from using borrowings to circumvent the new contribution caps becomes law.
Currently, there’s no question super remains the most tax-effective investment option out there, in spite of its lack of flexibility. Nonetheless, if you’re the trustee of an SMSF likely to be affected by the changes, there are alternative structures you could consider.
These structures could appeal on a number of levels. Australians with balances of over $1.6 million in retirement phase looking for alternatives to transferring the excess back to an accumulation fund are one group that could benefit. Investors affected by the new concessional and non-concessional caps are another group that may be looking at ways to invest excess funds outside of super. Knowing the pros and cons of the various options is always a good idea.
Setting up a private company can be a good way to defer tax
One option is to set up a private company to invest on your behalf. Because tax on company earnings is limited to 30 per cent, depending on your marginal tax rate, returns from investments held by the company may be taxed at a much lower rate than if you held them in your name.
On the other side of the coin, a company structure has certain limitations – chief of which is that it is only effective in deferring, and not permanently reducing, tax. As long as returns from investments remain in the company structure, they are only taxed at 30 per cent. Once distributions (in the form of dividends) are made, recipients must include these in their personal tax return and pay the difference between the company tax rate and their marginal tax rate.
The second drawback of the company structure is that creating and maintaining it can be expensive. Australian law requires a separate set of accounts and a tax return to be produced for companies every year, which can be an expensive exercise. In addition, while profits are distributed as dividends, there is limited flexibility in distribution.
A family trust offers a flexible, potentially tax-effective distribution strategy
A second option is to set up a family trust, otherwise known as a discretionary trust, to invest on your behalf. Investments are then held in the trust structure and trustees are able to distribute income and capital gains to beneficiaries in whatever way they desire.
Like the company structure, distributions from a discretionary trust are taxed at the marginal rate of the recipient, unless the distributions are made to a company.
The real benefit of a family trust lies in its flexibility. It is possible to vary the beneficiary of distributions each year, which may suit some families. For example, if the family includes low-income earners, there may be taxation advantages in distributing to them.
There are fees to set up and administer a family trust and these need to be considered as part of the decision-making process in evaluating whether to use a family trust.
Investment bonds – flexibility, tax-effectiveness and ease of transfer
The third structure you should consider is an investment bond.
An investment bond is technically an insurance policy, with a life insured and a beneficiary. It operates as a tax-paid managed fund. As with a managed fund, investors can choose from a range of underlying investment portfolios depending on their investment goals – from growth-oriented assets, such as equities, to defensive assets, such as cash.
There is no limit on the initial amount invested in an investment bond and additional contributions of up to 125 per cent of the previous year’s contributions can be made each year. Returns from the underlying investment portfolio are taxed at the company rate of 30 per cent within the bond structure and are then reinvested. They are not distributed as income. This means returns do not need to be included in the investor’s annual tax return.
In some cases, the effective tax rate on returns from the bond may be less than 30 per cent because dividend imputation and other credits may apply.
If the investment bond is held for 10 years, all funds are distributed personally tax-free, however, funds can be accessed earlier.
While fees are charged by the investment bond provider, as this is a pooled investment, these fees will often compare favourably to the company and trust scheme options. As with all investments, you should consider the costs of the structure selected.
Investment bonds can also be a flexible and simple option for estate planning. Proceeds from an insurance bond do not form part of an estate and are transferred to the beneficiary tax-free in the event of the death of the life insured under the bond. Even if the life insured dies before 10 years, proceeds are still transferred tax-free. And the investment bond can be an ideal way to save for a significant event in the future, such as supplementing retirement income streams, for example.
Despite the outcry when the changes to super were announced last year, the majority of changes passed into law and will come into effect on 1 July. It remains to be seen just how many Australians will be seriously affected and what, if any, the unintended consequences might be. What is clear, however, is that super is very much in the spotlight and now is the time to examine alternatives for tax-effective savings outside of superannuation.
With this in mind, SMSFs, and indeed all Australian investors, would be well-advised to look at what options exist outside of super and ask themselves whether they could be an effective investment option for them.
Summary of the changes most likely to affect SMSFs
Changes take effect from 1 July 2017
Transfer balance cap
A maximum of $1.6 million can be transferred to the tax-free retirement phase. Those with retirement-phase balances of over $1.6 million will have six months to transfer the excess out of super or back into an accumulation fund.
Concessional super contribution cap reduced
Concessional contributions to super are limited to $25,000 a year.
Non-concessional contributions cap reduced and new criteria introduced
Annual non-concessional contributions must not exceed $100,000 (dropped from $180,000).
Lowering of the income threshold from $300,000 to $250,000 for 30 per cent rather than 15 per cent tax on contributions. This means Australians with an income of $250,000 a year or more will pay 30 per cent, double the usual tax rate of 15 per cent on contributions into super.
Transition-to-retirement pensions will lose their tax-free status
Earnings on fund assets supporting a transition-to-retirement pension will be taxed at the same 15 per cent tax as accumulation funds.
Neil Rogan is investment bonds division general manager at Centuria Capital.