Many people face two financial planning challenges.
Firstly, their projected super balance may not be enough to fund their desired living expenses in retirement.
Secondly, they would like to enjoy the flexibility of being able to reduce working hours (or even retire in full) in their 50s.
Often, the solution to these two financial planning challenges is to establish what I have termed a ‘third super fund’.
Let me explain.
How long will your super last?
Over the next 5 weeks, I will be sharing video presentations discussing (in simple terms) 5 fundamental financial planning concepts.
One of the presentations discusses how to maximise your super and the table below is discussed in that presentation.
It gives you an indication of how long your super may last.
For example, if you have a total super balance of $1.5 million and want to spend $100k p.a., you should plan for your super to run out by the time you reach your mid-80s (86), assuming you retire at age 60.
How old will you be when you run out of super?
| Total super balance at age 60 | |||||||
|---|---|---|---|---|---|---|---|
| Annual Spending | $750,000 | $1,000,000 | $1,250,000 | $1,500,000 | $1,750,000 | $2,000,000 | $2,500,000 |
| $70,000 | 75 | 83 | 99 | Never | Never | Never | Never |
| $80,000 | 72 | 79 | 88 | 106 | Never | Never | Never |
| $100,000 | 69 | 73 | 79 | 86 | 97 | 122 | Never |
| $120,000 | 67 | 70 | 74 | 79 | 84 | 92 | 159 |
| $150,000 | 66 | 68 | 70 | 73 | 77 | 81 | 92 |
The problem is that we are restricted on how much we can contribute to super.
Annual caps include $27,500 for concessional (tax-deductible) contributions plus $110,000 for non-concessional (not tax-deductible) contributions.
Therefore, even if we have the money, we might not be able to get it all into super.
What if you would like to reduce working hours before age 60?
You can’t access super until you reach age 60, or younger if you were born prior to 1 July 1964.
My guess is that this age will be pushed back at some point (although there’s no talk of that happening yet), but probably not for anyone that is older than 40 i.e., at least 20 years away from reaching 60.
If you are younger than 40, I’d suggest you assume that you will be able to access super at around mid-60s (e.g., 67 is when people qualify for the Age Pension), just to be conservative.
Therefore, if you would like to have the flexibility to reduce working hours (or retire in full) before age 60, then you must have a pool of assets outside of super to fund living expenses.
The tax benefits of using an investment company
The benefit of accumulating investments in a (non-trading) company is that you will always get credit for any tax you pay.
That means, you may pay some tax now, which you can get refunded in the future (via imputation credits).
Australia is one of the only countries in the world that has a company tax imputation system.
This system tracks the amount of tax that a company pays.
The shareholders then receive a credit for any tax paid if the company pays them a dividend.
Let me explain with a simple example.
Let’s assume that you have an investment company that makes a $40,000 profit (consisting of interest and capital gains, for example).
You are aged 58 and plan to retire in 2 years.
The company will pay tax on its profit at the flat rate of 30% i.e., $12,000.
The company will then have $28,000 of remaining profit (being $40,000 less $12,000 of tax paid).
In two years’ time when you are retired, the company pays a fully franked dividend of $14,000 (half of the profit each) to you and your spouse.
Each person receives $6,000 of franking credits attached to their dividend (i.e., half of the tax already paid).
If you and your spouse have no other taxable income, you will receive a $6,000 tax refund when you lodge your return because your total taxable income will be $20,000.
In this example, you have paid company tax on the profit, left the profit in the company, and then paid it out when it was more tax effective to do so i.e., in retirement, to reduce your overall tax to nil.
Many people avoid investing in companies because of capital gains tax but…
Unlike individuals and trusts, companies are not entitled to the general 50% Capital Gains Tax (CGT) reduction if they own an asset for more than 12 months.
Instead, the gross capital gain is taxed at the flat rate of 30% (assuming it’s a passive investment company I.e., not a trading business).
That means companies pay 6.5% more in CGT i.e., 30% versus 23.5%, being half of the top marginal tax rate of 47%.
On the face of it, you may disregard investing in a company for this reason.
However, remember you always get credit for any tax paid.
Therefore, if a company makes a very large gain and pays 30% in tax, it might be possible to pay that gain out to shareholders over many years and get a refund for the tax paid.
We know from the previous example that you can pay out a pre-tax profit of $40,000 as dividends to two individuals and get a refund of 100% of the tax paid i.e., not pay any tax.
Therefore, if a company makes a gross capital gain of $800,000, it can be paid out over 20 years ($40k p.a.) and the investors ultimately avoid paying any tax.
Geared property is typically better in personal names
I would normally not recommend borrowing to invest in property in a corporate structure.
The main reason is that any negative gearing tax benefits will be trapped inside the company or trust.
My previous financial analysis confirms that negative gearing benefits are very valuable.
Shares are better in a company because you are able to progressively divest them.
How do you invest via a company?
The most common way we use investment companies is with a regular share market investing strategy.
That is, clients invest a set amount each month into the share market and this portfolio is owned by their company, as I’ve described in this blog.
If the client is self-employed, it is often possible for them to distribute business profit into this company to fund these investments (whilst capping their income tax rate at either 25% or 30%).
If the client is an employee, the contributions will be recorded as a loan to the company to allow them to withdraw their capital contribution in the future, without any tax consequences.
Depending on the amount invested, it is possible to add some gearing into the company e.g., the company can borrow to supplement the investors' contributions.
When trust can be just as good
A family trust can also be a good entity to hold investments, especially if we have individuals to distribute to who are in low tax brackets.
A trust can also distribute income/gains into a company (corporate beneficiary) to cap the tax rate at 30% if required.
What portfolio size warrants establishing an investment company?
A company costs approximately $1,500 to establish.
Ongoing costs include ASIC ($310 p.a.) and accounting fees.
Companies by law must maintain sufficient financial records, but that does not necessarily mean they must prepare financial statements.
Therefore, an accountant is only required to prepare and lodge a tax return for the company.
The cost associated with that depends on the size and complexity of the portfolio, but in most circumstances, that cost is likely to be circa $1,500 p.a.
All up, it is reasonable to assume the ongoing costs to run an investment company to be circa $2,000 p.a.
Whether it is worthwhile for you to establish an investment company is dependent on your individual circumstances.
As a very rough guide, an investment company is probably worthwhile considering if your investment portfolio is likely to exceed $500,000 in the next 5-10 years and/or you and your spouse both earn more than $200,000 p.a.
It’s super AND, not OR…
Superannuation is very tax-effective.
Everyone can have up to $1.9 million in super and pay zero tax!
Therefore, if you have a spouse, your goal should be to have up to $3.8 million (of your total wealth) in super by at least circa mid-60s.
The problem is that you can’t access super until age 60, so it doesn’t aid early retirement, and there are restrictions on how much you can contribute each year.
As such, often, an investment company or trust has a lot of merit.
