By Liam Shorte 21 Aug 2015

Increasing your tax-free super: The re-contribution strategy

It can make sense to withdraw your super and re-contribute it. Richard Livingston and Liam Shorte explain the ‘re-contribution strategy’.

Snapshot

  • This strategy can increase your ‘tax-free’ super
  • In some cases it can improve age pension outcomes
  • We outline the steps you need to take and the pitfalls to avoid

In Transitioning to retirement? Shift your super into pension mode we explained why you should consider taking a transition to retirement (TTR) pension when you reach your preservation ageThe age at which you can generally access your super (subject to satisfying a condition of release). A person's preservation age depends on their date of birth. For those born before 1 July 1960 it's 55, but it will gradually increase to 60 over coming years. See the ATO website for more information.. You should also start thinking about a ‘re-contribution strategy’.

We’ll explain the strategy and why you might use it in a moment, but first a word of warning.

Loss of grandfathering

If your current super pension is ‘grandfathered’ (exempt) from the new age pension Income TestOne of the two tests that determine eligibility for the Age Pension (the other is the Assets Test). The test that applies (dominates) is the one which gives the worst result. Details of how the Income Test calculations and limits can be found at the Department of Human Services website. deeming rules (see Age pension: Keeping your super pension grandfathered) this strategy could cost you some or all of your age pension.

Making a large withdrawal from your existing pension account reduces the amount that is exempt. Stopping your current pension would see you lose the grandfathering completely.

If you weren’t taking a super pension and age pension (or other entitlement) at 1 January 2015, this isn’t a problem. But if you were, then a re-contribution strategy will require you to factor in the impact on your age pension. We strongly recommend seeking personal advice if you’re unsure on the calculations.

Let’s now explain why you might use the re-contribution strategy.

Tax-free and taxable components

Your super balance consists of two components – tax-free and taxable. The tax-free component isn’t subject to tax when withdrawn, while the taxable component may be taxed, depending on your age and the circumstances under which it is paid (more below).

Broadly, the tax-free component represents non-concessional contributionsVoluntary contributions made to your super account out of after-tax income (savings). Non-concessional contributions are not tax deductible and can't be salary packaged. See the ATO website for more information. you’ve made to your super account since 30 June 2007 plus the ‘crystallised segment’ at 1 July 2007 (the crystallised segment was a one-off consolidation of a number of older components).

The taxable component is made up of everything else. The idea of identifying a tax-free component of your super is to prevent you having to pay more tax on cash contributions you’ve made from your own (previously taxed) funds.

When you start a super pension, it takes on the tax-free/taxable components of your account at the time. For example, if you start taking a super pension from an account that is 20 per cent tax-free/80 per cent taxable, your super pension will be deemed to be 20 per cent tax-free/80 per cent taxable from that point onwards.

Why do the components matter?

If you’re over 60 and taking a super pension, the entire payment is exempt from tax and the components don’t affect that. But the distinction is important in the following situations:

  1. Withdrawals before age 60. If you’ve reached your preservation ageThe age at which you can generally access your super (subject to satisfying a condition of release). A person's preservation age depends on their date of birth. For those born before 1 July 1960 it's 55, but it will gradually increase to 60 over coming years. See the ATO website for more information., but you’re under the age of 60, you’re taxed on the taxable component of any super pension, or lump sum withdrawal, at your marginal tax rateYour marginal tax rate is the tax rate that applies to the last dollar of your income. Australia has a progressive tax system where the marginal tax rate applied to individuals increases as your taxable income decreases. Current individual tax rates can be found at the ATO website. (less a 15 per cent tax offset and subject to the ‘low rate cap’ – see below).
  2. Death benefits. Death benefits are exempt from tax if they’re paid to dependants under the tax laws. While this includes your spouse and children under 18, it doesn’t include adult children (unless they can prove they are financially dependent on you). If a death benefit is paid to an adult child (or other family member or friend) the taxable component of the payment is taxed at 15 per cent plus Medicare Levy (the tax-free component remains exempt from tax).

A re-contribution strategy helps you achieve a better result in these situations by increasing the tax-free component of your super.

What is the re-contribution strategy?

The strategy (in the context of changing your super components) is simply to make a withdrawal from your pension account and re-contribute it as a non-concessional contributionVoluntary contributions made to your super account out of after-tax income (savings). Non-concessional contributions are not tax deductible and can't be salary packaged. See the ATO website for more information. to a new accumulation account. Taking these steps will reduce the balance of your ‘mixed component’ pension account and create an accumulation account that is entirely ‘tax-free’ (see example in Table 1).

Once you’ve made the contribution you can convert the accumulation account to pension mode and start a new tax-free super pension. The result is an increase in your overall tax-free balance and (for estate planning) the ability to stream the pension accounts to the most suitable beneficiaries. For instance, you can make your spouse the beneficiary of your mixed component pension account and have your adult children receive the tax-free pension.

Alternatively, you can roll-back (stop) the existing pension, add the accumulation account to it and start a new pension with a higher tax-free component than you had previously. However, this gives you less flexibility and can water down the effect of the strategy when doing multiple withdrawals and contributions.

The amount you can withdraw from a super pension account will depend on the age of the member whose account you are taking the money from. If they’re over 60 then there’s no tax payable on withdrawals (either pension or lump sum). You’ll be constrained by either the 10 per cent maximum withdrawal (if you’re taking it as a pension payment from a TTR pension account), or your non-concessional contributions cap.

If you’re between 60 and 65 don’t forget the ‘bring forward ruleThe colloquial term for the rule that allows you to accelerate (bring forward) three years worth of non-concessional contributions to super. See the ATO website for details.’. You’re entitled to bring forward’ three years non-concessional contributionsVoluntary contributions made to your super account out of after-tax income (savings). Non-concessional contributions are not tax deductible and can't be salary packaged. See the ATO website for more information., so you can potentially shift up to $540,000 in one hit (if you haven’t used it already). Those over the age of 65 will be limited to $180,000 (the current non-concessional contributions cap) and will also have to meet the work testIf you are aged 65, but less than 70, you can make super contributions but only if you meet a 'work test'. To satisfy this test you must work at least 40 hours during a 30 day period (in the financial year the contribution is made). See the ATO website for more information..

Things are a little different if you’re under the age of 60, since you’re taxed on the taxable component of a withdrawal at your marginal tax rateYour marginal tax rate is the tax rate that applies to the last dollar of your income. Australia has a progressive tax system where the marginal tax rate applied to individuals increases as your taxable income decreases. Current individual tax rates can be found at the ATO website. (less a 15 per cent tax offset). So you need to be careful you don’t end up with a tax bill.

The best way to achieve this is to make a lump sum withdrawal utilising your ‘low rate cap amount’. This is a one-off benefit that allows a person under the age of 60 to withdraw a lump sum (up to the cap – currently $195,000) free of tax, although it may impact Government benefits and other payments (see ‘Potential pitfalls’ below).

Remember, it’s only the taxable component of a lump sum that is taxed, so if you’ve got a mixture of tax-free and taxable, your total withdrawal can be more than the cap.

For example, if you’ve got a pension account that is 20 per cent tax-free/80 per cent taxable, you could withdraw up to $243,750 in total ($195,000 cap amount DIVIDED BY 0.8) without having to pay tax on it.

Ideally, you should limit the number of times you do a re-contribution strategy given the paperwork involved. But if, for instance, you can’t use the bring forward rule, you can spread your withdrawals over different financial years.

If you’ve only got a small amount sitting in a cash account and you want to avoid selling assets (see ‘The pitfalls’ below) then there’s nothing stopping you doing a re-contribution strategy on that amount over and over again. It’s just a question of how much work you want to do.

Uneven balances

That’s the re-contribution strategy for changing the components of your super. But there’s another situation where it can be useful: couples with uneven super balances.

Where a member of a couple has reached the age pension age (currently 65) and has a younger spouse, any accumulation super account of the younger person is excluded from the age pension Assets TestOne of the two tests that determine eligibility for the Age Pension (the other is the Income Test). The test that applies (dominates) is the one which gives the worst result. Details of how the Assets Test calculations and limits can be found at the Department of Human Services website. and Income TestOne of the two tests that determine eligibility for the Age Pension (the other is the Assets Test). The test that applies (dominates) is the one which gives the worst result. Details of how the Income Test calculations and limits can be found at the Department of Human Services website., until they start a pension or reach age 65. Withdrawing from the older partner’s account and contributing to the younger partner’s can increase the amount of age pension the older person is entitled to.

Uneven balances could also be a problem in the future if, for instance, a tax is introduced for larger super accounts. In this case, you might want to shift super into the super account with the lower balance.

Obviously, there’s a trade-off between these two objectives. Making the younger spouse’s super balance much larger increases the risk of future taxation, although this is more likely to be a concern if the younger spouse’s balance ends up at, say, $2 million or more.

There’s also a trade-off between increasing the age pension outcome for the older spouse and minimising tax on the younger spouse’s super account, since only accumulation super accounts are excluded. If the younger spouse wants to convert their super to a pension account (to take advantage of the zero tax rate) the exclusion will be lost.

Finally, this benefit only lasts until the younger spouse reaches the age when they’re eligible for the age pension themselves. Once they reach pension age, it will be included in the couple’s assets for the Assets TestOne of the two tests that determine eligibility for the Age Pension (the other is the Income Test). The test that applies (dominates) is the one which gives the worst result. Details of how the Assets Test calculations and limits can be found at the Department of Human Services website. and deemed under the Income TestOne of the two tests that determine eligibility for the Age Pension (the other is the Assets Test). The test that applies (dominates) is the one which gives the worst result. Details of how the Income Test calculations and limits can be found at the Department of Human Services website. calculations.

This makes the re-contribution strategy in this case more valuable when there’s a large age gap between them. Note though, if you’re keen to minimise your super withdrawals, shifting super to the younger spouse’s account means the minimum pension amount won’t increase (on the amount shifted) when the older spouse turns 75.

Potential pitfalls

There’s a number of traps to watch out for when considering a re-contribution strategy:

  1. Contribution limits. Your ability to re-contribute is limited by the non-concessional contributions cap. Based on current limits, you can contribute $180,000 in a year, or $540,000 if you’re able to use the bring forward ruleThe colloquial term for the rule that allows you to accelerate (bring forward) three years worth of non-concessional contributions to super. See the ATO website for details.. Exceeding these limits can expose you to penalties.
  2. Over 65s. Remember, if you’re over 65, you’re no longer entitled to the bring forward ruleThe colloquial term for the rule that allows you to accelerate (bring forward) three years worth of non-concessional contributions to super. See the ATO website for details. and you need to satisfy the work testIf you are aged 65, but less than 70, you can make super contributions but only if you meet a 'work test'. To satisfy this test you must work at least 40 hours during a 30 day period (in the financial year the contribution is made). See the ATO website for more information. in order to make contributions to super.
  3. Low rate cap. If you’re under 60 and withdraw more than your low rate cap, you’ll end up paying tax on any excess. Even if you’re under the cap, you should note that the zero tax outcome is achieved by giving you a tax offset (credit). This means the lump sum is still included in your assessable (taxable) income and may affect the calculation of Government benefits (eg Family Tax Benefit) and other payments. Check with a Centrelink Information Service officer or seek personal advice if you’re unsure how you’d be affected. 
  4. Anti-detriment payments. If you’re planning an anti-detriment strategy, any potential anti-detriment payments (an increase to the death benefit due to a refund of contributions tax paid during the accumulation phase) that a surviving beneficiary may be entitled to may be reduced (or lost). But anti-detriment strategies are generally the domain of large super funds and are rarely implemented in the SMSF sector as they’re not simple and come with uncertain results. Most people prefer the upfront certainty of having an increased tax-free component.
  5. Condition of release. Remember, to access your super you must have met a ‘condition of release’ (which will typically be; reaching your preservation ageThe age at which you can generally access your super (subject to satisfying a condition of release). A person's preservation age depends on their date of birth. For those born before 1 July 1960 it's 55, but it will gradually increase to 60 over coming years. See the ATO website for more information. and commencing a TTR pension; retiring after age 60; or reaching age 65). Withdrawing from your super without having met a condition of release is a serious breach.
  6. Transaction costs. If you need to sell assets in order to make a withdrawal from your pension account, you may have to pay brokerage, incur a bid/offer spread or suffer other transaction costs. If you’re selling investments, there will also be a period where you are ‘out of the market’ so you may lose out if prices increase before you repurchase the investments. Make sure you assess the costs of a re-contribution strategy before implementing it.

Ideally, a re-contribution strategy will use cash your SMSF has sitting in a bank account so that transaction costs are kept to a minimum. If you’re happy to spend the time doing the paperwork yourself, you can always implement the strategy more than once if your fund doesn’t have enough spare cash. It’s a question of how much work you want to do.

The re-contribution strategy should be low cost (or no cost) but the benefits are highly fact dependent. In Part 2 we’ll run through a number of case studies to show when a re-contribution strategy makes sense and when it doesn’t.

 

Liam Shorte is a principal of Verante Financial Planning Pty Ltd (www.verante.com.au), a corporate authorised representative of Magnitude Group Pty Ltd (AFSL 221557). This article is a general information article and to the extent it contains any financial advice it is general advice only. We recommend seeking personal advice on your own circumstances.

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Note: this article was originally published with a reference to the old low rate cap amount of $185,000. It has now been corrected.