There are only two reasons why people save for their retirement in the superannuation system. One, they are forced to by the compulsion of the Superannuation Guarantee, and two, to take advantage of the favourable tax treatment. The latest tightening of concessions is coming with the new 15% tax on balances over $3 million, and it adds another layer of decision-making for those affected. It is no longer straightforward that the more in super, the better.
Tax planning can become extremely complex and nuanced for individuals. This article looks at the major investment pool choices and taxes but does not attempt to address every individual circumstance.
Access to superannuation
The tax advantages of superannuation come at the cost of lack of access until one of the Conditions of Release is met. However, despite successive governments and reviews confirming super is intended to finance retirement, there are no limits to taking money out of super when the member:
- has reached their preservation age and retires
- ceases an employment arrangement on or after the age of 60
- is 65-years-old, even if they haven't retired.
Therefore, when a government introduces a new super tax, most members in retirement can adjust their investment structures and if advantageous, take money out of super without paying an exit tax. The new 15% super tax brings other choices into focus.
The tax hierarchy of investment pools
The new tax may bring a level of complexity to investment pool allocation which is more trouble than it is worth. It's a personal decision but many people do not want to spend their retirement years, after decades of working hard, balancing investments between different pools to minimise tax.
On the other hand, retirees are affronted by the constantly-changing rules, when all they have done is used the superannuation system to save as they were encouraged to. They feel the rules of the game are tightening because they have played it well, and they will respond accordingly.
The simpler world of the past was to own a home by the time of retirement, leave some money outside super to spend, and hold as much in super for the tax advantages. For those who can be bothered, it’s not so simple anymore.
Let’s consider the investment pools according to tax treatment.
Pool 1. Investments outside super using tax-free thresholds
Personal income tax is calculated using tax-free thresholds with concessions for older people, such as the Senior Australians and Pensioner Tax Offset (SAPTO). For Australians generally, the tax-free threshold is $18,200, but for those subject to SAPTO, personal incomes less than about $32,000 for individuals and couples combined above $58,000 are tax-free. Some people will avoid the complexity and costs of other structures by investing in their own names but check eligibility using a SAPTO calculator.
Pool 2. Superannuation in pension mode
A pension fund is tax-free for both income and capital gains, and the member pays no tax on a pension received. The Transfer Balance Cap (TBC) which places a limit on the amount that can move from accumulation to pension was initially set at $1.6 million, is currently $1.7 million and will move to $1.9 million on 1 July 2023. These limits are per person meaning a retired couple will soon have access to $3.8 million when opening new pension accounts (existing caps do not change).
In a few years with indexing and inflation staying stubbornly high, these limits will reach the $3 million level, as the TBC is indexed but the $3 million cap is not. Over time, hundreds of thousands of people will start balancing the opportunities of tax-free super against the $3 million tax.
It is sometimes claimed that Pool 2 is superior to Pool 1 because Section 116(2)(d) of the Bankruptcy Act provides that superannuation is excluded from property divisible amongst the creditors of a bankrupt person.
Pool 3. Investment in a Principal Place of Residence
Although many people argue a home is not an investment, the favourable tax treatment for social security eligibility and lack of capital gains tax means many Australians consider their home as a place to store wealth. The tax system encourages expensive homes and renovations as a way to both enjoy wealth tax-free and qualify for government benefits. There is no cap on this expenditure and a person can live in a $10 million home and receive a full age pension.
The above three pools allow investment without paying any tax.
Now we move into the pools which minimise but not eliminate tax.
Pool 4. Superannuation in accumulation mode
In accumulation mode, earnings are generally taxed at 15%, although there are further concessions for capital gains on assets held for longer than 12 months. Franked dividends can also offset tax liabilities.
Pool 5. Superannuation balances over $3 million
The new tax will commence on 1 July 2025 and apply from the 2025-26 financial year onwards for individuals with more than $3 million in super on 30 June 2026. Firstlinks has covered the choices and consequences extensively and we will not repeat all the alternatives in this summary.
It is incorrect, however, to describe this as a 30% tax regime, by adding the 15% tax in accumulation mode and the new 15% tax on balances over $3 million. The definitions of ‘earnings’ in each are radically different, with the most notable being the taxation of unrealised capital gains in the high balance calculation.
An asset that rises in value by say $1 million in a financial year will face the new $3 million tax calculation, but if unrealised, it is not in the first 15% tax on accumulation funds. It may also not be taxed at 15% because it is the proportion over $3 million that is taxed. Plus it is possible to hold $3 million in a pension account which is taxed at zero, then pay 15% on the rest, without paying 30% in total.
The additional 15% tax brings into play comparisons with other tax structures which pay tax at 30% but are not subject to the tax on unrealised capital gains.
This is where the new tax changes the game for those planning their tax affairs according to the tax consequences.
Pool 6. Family trusts
A trust is a structure that holds assets on behalf of beneficiaries. Family trusts are used to distribute income, and therefore tax obligations, amongst multiple family members, especially to lower-income earners.
For example, a family trust might include two high-income parents on the highest marginal tax rate and two children who are adult full-time students with no other income. The investment income could be redistributed to the students, subject to special rules on taxing income of minors under 18-years-old.
A trust must distribute income in the same year the income is earned but it cannot distribute losses which can be used to offset capital gains either in the same year or carried forward. Trusts are eligible for the 50% capital gains tax discount after holding an asset for over 12 months.
Anyone setting up a trust should seek professional advice and expect ongoing costs, and there are other factors to check. For example, some Australian states charge higher land taxes on trusts.
Pool 7. Private investment companies
Investors can place money into a personally-controlled company which is a separate legal entity. Unlike a trust, there is no requirement for a company to distribute income each year, allowing the company to accumulate assets like other savings pools such as superannuation.
The tax rate is 25% or 30% depending on circumstances, which may be less than marginal tax rates. When dividends are paid by the company, the franking credits held by the company pass to the recipient.
A company is not eligible for the capital gains tax discount afforded to individuals and trusts. Companies have initial set up costs, ongoing advice and administration costs.
Investors may utilise a structure where one of the beneficiaries of a trust is a 'bucket' company. The company receives income from the trust which is then invested by the company and taxed at company tax rates rather than higher marginal personal tax rates. Assets can be held in the company and income distributed later. One advantage of this structure is the earnings in the company are not subject to tax on unrealised capital gains, as the new $3 million super tax imposes.
Financial advisers and accountants are already promoting this structure to clients.
Pool 8. Others such as investment bonds, family loans and philanthropy
All investment portfolios are unique based on individual preferences and circumstances, and an infinite array of ways to accumulate wealth or spend money. Many alternatives can fit into this final pool but three are increasingly popular.
One, investment (or insurance) bonds will become more competitive due to higher tax rates on super and are worth considering by anyone who has a marginal tax rate greater than 30%. As long ago as 2015, Firstlinks published an article called, “Will insurance bonds become the new superannuation?”.
Two, with the rise in residential property prices and interest rates, adult children increasingly rely on the Bank of Mum and Dad (and maybe the Bank of Grandfather and Grandmother) to buy a home. Instead of leaving money to children in an estate, parents gift or loan money earlier. It has also become common for bequests to skip a generation and go straight from grandparent to grandchild.
Three, with wealth accumulated, more people turn to philanthropy, including giving to charities or opening Public or Private Ancillary Funds, which not only help those less fortunate, but give the donor a tax deduction.
Interplay between pools
Faced with many choices, investors do not need to set and forget. They can rebalance between the pools regularly as values rise and fall and tax implications change.
For example, while the limits on the amounts that can be invested in superannuation continue to tighten, there are no limits to the amounts invested in companies, trusts or insurance bonds.
When personal taxable income is less than the tax-free threshold, the company can pay dividends into the pool allocated for personal income, until the pool is full. Where more income is needed, a company can pay back some of the money invested.
Money must be drawn out of a superannuation pension fund each year according to mandated minimums.
And critically, at some stage, a major decision is required when to transfer money out of super to avoid the 17% ‘death tax’ when super is inherited by a non-dependant who is not a spouse.
How does this relate to the common ‘bucket’ strategies?
The use of these pools based on expected tax treatment should not be confused with the common financial planning technique of using ‘buckets’ to manage income needs.
This strategy involves dividing a portfolio into different buckets according to expected cash flow needs. There is a cash bucket of highly-liquid assets for living expenses, maybe based on cash needs for a few years to avoid selling down a share portfolio if the market falls. A second bucket might include bonds or term deposits that provide income but mature in three or four years. Riskier assets such as shares are placed in a third bucket for longer-term growth.
This bucket strategy can operate alongside the pools. For example, a retiree could include cash in each of a superannuation, personal or company pool and draw out as needed. However, a product like an investment bond would need to fit into a longer-term bucket.
Graham Hand is Editor-At-Large for Firstlinks. This article is general information and does not consider the circumstances of any person, and personal financial and tax advice should be obtained by anyone considering the complexities of using different pools for their investments.