Superannuation funds receive franking credit refunds simply because their marginal tax rates are low, and for no other reason. This point seems to be lost on many people in the debate about whether franking credit refunds are fair.
Franking credits are fair because they transfer all company profits (not just the dividend) to the personal tax system which are then subject to progressive marginal tax rates. Taxpayers with the highest income not only pay more tax, they pay a greater proportion of their income in tax.
The super fund is the taxpayer
It is the super fund, not the member, that is the shareholder and taxpayer and the recipient of any franking credit refund. The fund member never owns the shares and never receives a franking credit refund, not in SMSFs, nor as members of industry funds even where they invest in a Direct Invest or Member Direct Option.
But many people question the fairness of a tax-free retirement, for which they blame Howard/Costello in 2007.
Before 2007, fund members paid some tax when they withdrew money in retirement. Costello made all member withdrawals from super for both pensions and lump sums, tax-exempt after the age of 60 but left the tax on superfunds unchanged. There is a pervasive view that Costello forfeited a lot of tax through that decision. I think that is a myth, as I explained in this earlier Firstlinks article.
In summary, that tax on withdrawals only applied to the taxable portion of the fund and the member was also entitled to a 15% tax rebate in compensation for the taxes applied earlier to contributions and investment earnings. That tax arrangement is still in place for taxes on death benefits. By definition, large funds had small taxable portions because they became large only from large non-concessional contributions. For smaller funds, the rebate eliminated most of the tax payable.
Restrictions on large contributions
Costello’s other change was more important than people realise. He stopped unlimited contributions of after-tax money into super. It is no longer possible for to accumulate several million dollars in super (barring an investment windfall).
Previously, these large accumulation funds became very large tax-free pension funds, entitled to very large associated franking credit refunds. Some of these large funds still exist. The Retirement Income Review identified 11,000 people with more than $5 million in their super and some funds are much larger than this. According to James Kirby, The Australian, 10 September 2021, we are now at a point where a tiny number of mega funds, linked with less than 100 people, control more than $10 billion. These funds are clearly not required for a comfortable retirement, but they do make a very favourable estate planning tool.
The changes introduced in 2017 closed that favourable tax treatment. Tax-free pension funds are now limited by the Transfer Balance Cap of $1.7 million, and the excess is moved to an accumulation fund which is subject to tax. It is also no longer possible to make after-tax contributions once you reach your Total Super Balance Cap.
All contributions are taxed
Super became compulsory in 1992 with the complex tax rules we now have. All contributions are now taxed before they are invested, and all investment earnings are taxed while in accumulation mode. A super fund paying a pension in retirement has been tax-free since 1992 and since 2007, those withdrawals from the fund are also tax-exempt.
The original plan was to allow all contributions and investment earnings to be tax-free inside super and then to tax retirement benefits at 30%. Aside from the fact that a 30% tax rate would mean no franking credit refunds, this method would have had two distinct advantages.
First, superannuants would accumulate larger nest eggs as compounding over 30-40 years would be applied to total investments rather than the after-tax (85%) portion.
Second, this would avoid the inter-generational envy caused by the favorable tax treatment for retirees. This method was not adopted because the government was not prepared to wait 30-40 years to collect any tax from super, but that system is difficult to change now.
There remain many critics of the tax-free status of pension funds. Let us consider this favourable tax treatment.
The main reason for the super tax concessions is to ease the pressure on the age pension as retirees live longer. Changes to the downsizer contributions and the work test have the same effect. Similarly, franking credit refunds extend the life of a super fund’s capacity to pay a pension and thereby delay a retiree’s dependence on the age pension.
For the government, the cost of tax concessions in retirement needs to be offset against age pension costs. Valid comparisons are difficult because super tax concessions represent tax foregone but the projected tax that might be collected if this money was invested elsewhere is only a guess because it would involve different costs and benefits for taxpayers. Moreover, the super system is not yet mature as retirees today did not benefit from super all their working lives and then only at low levels at the beginning.
Nevertheless, the Retirement Income Review shows that super in retirement is already reducing the cost of the age pension.
For individuals, a tax-free pension is not cost free
By design, the more super you accumulate by retirement age, the less age pension you are entitled to. A couple will have their age pension reduced when their assets exceed $405,000. They become ineligible for any age pension once their assets exceed $891,500. Note that the family home is not assessed in this calculation. If they have $1 million in a super pension and earn $50,000 tax-free, they may cost the government $4,500 in forfeited income tax but they save the government $37,923 in age pension that they cannot claim.
Some age pensioners may question the wisdom of saving so diligently.
On the other hand, age pensioners enjoy a risk-free, tax-free, lifetime annuity that requires no personal effort. They could enjoy this annuity for more than 25 years, so the cost to the taxpayer can be very high.
A tax-free super pension is the incentive and reward for locking money away in a super fund for up to 40 years but it comes with a huge opportunity cost. Absent a pandemic, there is no access to this money for other purposes such as housing, education or travel. You must also trust successive governments to not change the rules. This explains why many young people do not contribute more than the minimum required.
In addition to these constraints, super pensions also have mandatory cash withdrawals that increase with age. At age 90 the mandated withdrawal is 11%. Failure to meet this requirement means the loss of the fund’s tax-free status. The purpose and effect of this requirement is to progressively remove capital from super that it is then subject to normal tax. This reduces any concessional money left in the estate. Super balances at death may also be subject to a death tax.
A tax-free super pension represents a social contract. A breach of faith would cause alarm to those who have accepted these conditions for the last 30 years.
There are undoubted benefits associated with a tax-free retirement, which is available to all. The fact that the government needs to compel Australians to save for their own retirement through the Super Guarantee, though, suggests that many people remain unconvinced of those uncertain future benefits.
The zero-tax rate applies to all super pension funds. That tax rate could be changed by an act of parliament, but such a change would impact the retirement benefits of all Australians.
Jon Kalkman is a former director of the Australian Investors Association. This article is for general information purposes only and does not consider the circumstances of any investor.