The media has a lot to answer for.
It seems that every time the world share markets have a volatile week, the headlines scream “Australian super funds tumble by $20 billion” or “Super funds on rollercoaster ride”.
Reading sensationalist headlines like these, you’d be forgiven for thinking Superannuation is an investment – and that you’d be just as well off avoiding super and choosing another less volatile investment.Most Australians have their superannuation invested in a default Balanced Fund, with around 70% allocated to Australian shares, International shares and Commercial Property, with the other 30% allocated to Fixed Interest (Bonds) and Cash. So if the share market drops, so does the average Australian’s super value. The media love linking the two together to generate emotional headlines, and sell papers.
But the fact is super is a tax structure, pure and simple; like a company or family trust, just with very different rules and regulations. You can choose to invest within superannuation however you like (provided the rules allow).
Looking at super in this way, in conjunction with changes to the rules around super fund options, is opening up a new world of opportunities for savvy investors.
No doubt, investors will continue to be frustrated with Governments of all persuasions continually tinkering with super rules – but regardless of future changes, it’s highly likely super will remain the best tax structure available.
Types of super funds
While all super funds operate under the same laws, not all super funds are the same. There are 3 main types:
- Industry & Employer super funds: low cost and lower investment option funds
- Retail & Wholesale funds: wide variety of investment choice, but usually a bit more expensive (especially retail). Wholesale can be a good option for those who want wider investment choice without the added responsibility of a Self-Managed Super Fund.
- Self-Managed Super Funds (SMSFs): widest variety of investment choice. A SMSF is effectively a “family fund” that can have up to 4 members. All members are trustees and all trustees are members. Usually SMSF’s have a single member or a couple amalgamating their super and investing together. The key benefits of a SMSF are control and direct ownership.
Regardless of the type of fund you choose, there are two stages for your super – Accumulation Phase and Pension Phase.
Accumulation phase is the period where you make contributions to your super – usually through employer contributions on your behalf, which are legislated at 9.25% of your salary. However you also have the ability to make personal contributions, which can yield significant tax benefits if structured correctly; eg if made pre-tax (‘salary sacrifice’).
The tax rate on pre-tax contributions is 15% compared to your marginal tax rate. So someone earning over $80k on the 38.5% tax bracket can receive a 23.5% tax saving on amounts salary sacrificed pre-tax into super; better in your pocket than the ATO’s.[sam id=37 codes=’true’]
After-tax personal contributions of up to $150,000 per year can also be made under the age of 65 (or up to $450,000 over a 3 year period). There is 15% tax on earnings within the Accumulation phase and 10% on capital gains on assets owned for more than 12 months. Not to be sneezed at.
The pre-tax contribution limit for those under 60 is $25k, and $35k if aged 60 and over. From next financial year those aged 50 and over will be able to contribute $35k, and those under 50 can contribute $30k.
However the major benefit of the super environment comes in Pension Phase, which is available to commence from age 55-60 (depending on your date of birth). There is NIL tax on the earnings within Pension Phase: 0% tax on investment income and 0% tax on capital gains.
Any money withdrawn from superannuation after the age of 60 is also tax-free. Between 55-60 amounts withdrawn are partially taxable however a 15% rebate is available to offset part of the tax.
Whether or not a person should contribute further pre-tax contributions over and above the 9.25% on wages depends upon cash flow, their age as well as the overall situation, however a person on the 38.5% tax rate (earning between $80k – $180k) saves 23.5% tax by making pre-tax contributions into super.
These tax savings can have an enormous compounding benefit by allowing these contributions to be invested in the 15% tax environment of Accumulation phase and grow and compound at the lower tax rate over time.
Also, in Accumulation phase half the franking credits from dividends are refunded to the super fund, and in pension phase the full franking credit is refunded. This is a hidden tax benefit that is commonly overlooked which can have a huge beneficial impact on the long term after-tax return.
The rise of Self-Managed Super Funds (and using an SMSF to buy property)
There are around 450,000 SMSF’s in Australia – and growing – yet they’re not for everyone. SMSF’s are only really appropriate for people wanting to run their own Superannuation share/investment strategy and/or invest in direct residential or commercial property.
SMSF’s can even now borrow to invest in property (under very specific rules). The drawback of having your own SMSF is the added responsibility of being a trustee and the compliance requirement to have annual tax returns and audits prepared.
Many of our clients have a strategy to buy a number of properties outside of superannuation with the view that this would be their superannuation, and they would live off the rental income in the years ahead.
While this can be a powerful wealth creation strategy, they will pay tax on the rental income forever. And when they sell a property there will be a significant amount of Capital Gains Tax (CGT) to pay.
Now that Self-Managed Super Funds can borrow to buy property, superannuation is becoming more relevant (and a lot more interesting) to more people for the following reasons:
- SMSFs no longer need to buy a property with 100% cash – they can now borrow up to 80% to fund purchases
- Investors whose borrowing capacity is maxed out outside of super can open up additional purchasing power through their superannuation
- You gain greater control of one of your biggest investments (your super)
- Enjoy significant tax savings on rental income and CGT
- With enough cash reserves, you can still ensure your nest egg is diversified
It’s important to note that the primary benefit of buying property through an SMSF is leverage – using the bank’s money to buy quality growth-oriented assets (exactly the same reasons as buying property outside of super). Any tax benefits you may receive are secondary.
While opinions vary, my view is that an SMSF should have a minimum balance of $150k-$200k if you are looking to invest in property to a) make it cost effective and b) ensure you still have the liquidity and diversification to reduce the risk of being overweighted in property.
A 45 year old couple buy a $500k investment property in their SMSF, and let’s assume the property doubles every 10 years (as it has for the past 40 years). Based on this assumption, by their planned retirement at age 65, the $500k property would have doubled twice to $2 million.
If this property is held throughout their retirement, the rental is tax free in Pension phase. If the property was sold at 65 to generate liquidity there is $0 capital gains tax in pension phase compared with around $300k that would apply if the property was held outside of super.
(Granted, with the 15% levy on super contributions for those earning over $300k, it does reduce the tax benefits of pre-tax super contributions for high income earners – however a tax free income stream should not be ignored).
If you’re looking to build an income stream in retirement to cover the lifestyle that you want in an ongoing sustainable manner, a major consideration is the amount of tax you’ll pay along the way – both in the accumulation and drawdown (pension) phases.
I’m a firm believer in building multiple streams of income and not being too reliant on one particular avenue to achieve your goals. While nobody should contribute all their money into super just because it’s a low tax environment, I believe that Superannuation should be a significant part of most people’s future retirement plans.
As everyone’s situation is different, it’s vital you seek expert advice regarding your personal situation before buying property using your super. It’s definitely not for everyone, and should only be done as part of an overall wealth creation strategy, but there are significant benefits for those who meet the key criteria.
There are very specific rules around purchasing property and borrowing using an SMSF – if you don’t get the right structure in place initially and follow the correct process, you can negate any potential tax benefits.
(We’ve had highly experienced property investing clients try to do it themselves and make mistakes which have cost them significantly – so it’s worth getting expert advice). Use an experienced team who are intimately aware of the correct strategy to ensure you maximise the benefits of this option.