By Liam Shorte 24 Aug 2015

Increasing your tax-free super (Part 2): Re-contribution strategy case studies

We run though a series of practical examples to highlight the benefits and pitfalls of the re-contribution strategy.

Snapshot

  • Kathy (under 60) uses the strategy to eliminate the annual tax bill on her super pension
  • Victor (over 60) eliminates the potential tax payable on any death benefit
  • Gareth and Kelly are able to access the age pension and Pensioner Concession Card.

In Increasing your tax-free super: The re-contribution strategy, we explained the benefits of withdrawing from your super and re-contributing it. We also highlighted some of the pitfalls.

Here, we’ll use a number of case studies to explain the benefits and pitfalls in more detail, starting with Kathy.

Reducing tax under age 60: Kathy (aged 57)

Kathy is 57 years old and has $1.5 million in her super account, with an 80 per cent taxable component and 20 per cent tax-free. She’s just retired (so has satisfied a ‘condition of release’) and would like to start a super pension.

What happens if Kathy simply takes the minimum super pension (4 per cent of her account balance) of $60,000 a year? Until she turns 60, she would be taxed on 80 per cent of it (the taxable component) at her 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. (including Medicare Levy) minus a 15 per cent tax offset. If she had no other income, her tax bill would be around $900 a year (it would be a lot more if she also had income from, say, a term deposit).

The re-contribution strategy is a simple way to reduce it. Let’s take a look at what Kathy needs to do.

Kathy has satisfied a condition of release, so she’s entitled to take a lump sum from her super account and – because her age is between 55 and 59 – she’s entitled to the low rate cap. This means she can withdraw up to $195,000 of ‘taxable’ super and the Tax Office will give her a credit to eliminate all the tax payable on it. Since her balance is 80 per cent taxable, she can take a lump sum of $243,750 ($195,000 divided by 0.8) without tax being payable (although note our comment in the previous article that this might affect other items based on taxable income, like Family Tax Benefit or Child Support).

After withdrawing this amount, she can put it back in an accumulation account 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.. Because it’s over the annual non-concessional contribution cap (currently $180,000 a year), she’d need do this over two years or utilise 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.’ to do it in one hit.

Once done, her super components change dramatically (see Table 1). If she goes ahead and converts the new accumulation account to a pension account, she can take two pensions totaling $60,000 but completely eliminate her tax bill.

This simple strategy will save her roughly a thousand dollars each year. If she had a higher super balance, or other income, she would have saved a lot more.

The strategy also has the additional benefit of reducing the potential tax on any death benefits paid to adult children (or other non-death benefit dependants) if she were to pass away. Let’s now turn to a case study that deals with that example.

Reducing tax exposure on death benefits: Victor (age 62)

Victor is a retired 62 year old, with a super pension account totalling $2 million (like Kathy’s, it also has an 80 per cent taxable component). He plans to complete a binding death benefit nominationAlso known as a BDBN. A BDBN is a document given by a super fund member to the super fund trustee. A valid BDBN legally compels the trustee to pay death benefits as directed by the member. instructing his super fund trustee to pay $1 million to his wife, Ann and to split the remainder equally between his three children – aged 16, 20 and 24.

As things stand, a death benefit payment could go to Ann and the 16 year old free of tax, as they are both ‘death benefit dependants’. But the taxable component of the payments made to the adult children would generally be taxed at either their 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., or 15 per cent (whichever is lower). It’s also subject to the Medicare Levy.

Assuming the adult children are working full-time, that’s a total of $110,000 in tax. Again, this is where the re-contribution strategy can help.

Victor has permanently retired (meeting a condition of release), so he’s entitled to withdraw an unlimited lump sum from his pension account and because he's over 60 it's tax free. He’s also allowed 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.’ to accelerate 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. (since he’s under 65). Let’s assume he withdraws a $720,000 lump sum from his super pension and returns it to his super account by making 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. of $180,000 on 30 June of this year and another $540,000 ‘bring forward’ 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. on 1 July.

The impact on his super account is set out in Table 2. Because the 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. is entirely tax-free, his super account has gone from being largely ‘taxable’ to roughly a 50/50 mix. Best of all, he can nominate that the trustee pay the adult children’s death benefit from the new pension account (which is entirely tax-free). As a result, the potential tax bill on the death benefit payments is now zero.

Note also that, if he didn’t eliminate the potential tax bill first time around, three years down the track (if he is able 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. for those aged over 65) he’d be able to do more withdrawals and contributions. Depending on how often he is able to do this, his super account might end up almost entirely ‘tax-free’.

Reduced change of law risk

The other benefit Victor gets from this strategy is that the lower taxable balance should reduce his exposure to future super rule changes. For instance, let’s say the Government decided to impose a ‘pension tax’ on accounts with a taxable balance exceeding $1 million. By using the re-contribution strategy, Victor has reduced the ‘excess’ taxable amount from $600,000 to $24,000.

Shifting super to a younger spouse: Gareth (age 66) and Kelly (age 53)

Gareth is a 64-year old retiree, married to Kelly, age 53 (born April 1962), who still works full-time. Gareth has $1.2 million in a super pension account and plans to apply for the age pension when he turns 65. Kelly has $200,000 in her accumulation super account.

If they did nothing, 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. would prevent Gareth getting an age pension and Pensioner Concession Card (or the Commonwealth Seniors Health Card (CSHC)). Home-owning couples need to have less than $1,151,500 (based on current limits) in combined assets in order to collect a partial age pension.

Note: for the CSHC, couples must have an assessable income of less than $82,400. From 1 January 2015, income from account-based superannuation income streams is included in the CSHC income test.

But what if Gareth withdraws $180,000 as a lump sum from his pension account and Kelly uses the money to make 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 her accumulation account?

The good news is that accumulation accounts belonging to a spouse who is too young to qualify for the age pension (below age 65 under the current rules) are exempt 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.. After withdrawing $180,000, Gareth’s pension account will fall to $1.02 million and (because Kelly’s super account is excluded) this is the amount of their combined 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. (note that in real life a couple would probably have other assets that need to be accounted for).

The re-contribution strategy helps Gareth qualify for the age pension and Pensioner Concession Card (PCC) when he would have otherwise missed out. Depending on his circumstances, his card use alone could be worth thousands of dollars each year. If Gareth’s super balance was already low enough to qualify for a partial age pension, this strategy could be used to increase the amount he’s entitled to.

Trade-offs with shift to a younger spouse

Unfortunately, this strategy isn’t always a ‘no-brainer’; there’s trade-offs involved. Kelly ends up with $380,000 in her accumulation account, which is subject to 15 per cent tax (10 per cent on long term capital gainsThe profit that an investor makes when they sell an investment or (if unrealised) the profit they would make if they sold the investment for its value at that time.). In the current low interest rate environment, this is unlikely to add significant costs. If the additional $180,000 earns around 3 to 4 per cent income each year then the additional tax bill would be less than $1,000. But if Kelly realised large capital gainsThe profit that an investor makes when they sell an investment or (if unrealised) the profit they would make if they sold the investment for its value at that time. before switching her account to pension mode (and note that some industry and retail super funds force you to do this) then the extra tax could be more substantial.

When Kelly reaches her 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. of 57 (based on her April 1962 birth date) she may decide she wants to switch her accumulation account to pension phase – either by starting a transition to retirement, or account based, pension. At this point, her account balance will be included in 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 Gareth might lose his age pension.

For this reason, this strategy works better with much younger spouses, or where the couple is very close to qualifying for the age pension and the younger spouse has very little super. If Kelly was 62 in our example, but had virtually no super, it might still be worth transferring the $180,000 to her and leaving it in accumulation until she becomes eligible for the age pension herself.

Finally, an additional benefit of using this strategy is that Gareth has reduced his super balance and (like Victor above) this should reduce his exposure to future law changes, including taxes on large super balances. But on the downside, if preservation ages were increased, Kelly might not be able to access her account for longer, so they’d have more money locked up in a taxable accumulation account.

Of course, the benefits of this strategy (and whether it’s of benefit at all) depend on the individual situation. For example, the need for Gareth to withdraw a higher percentage from his super (to compensate for the lower balance), his use of the age pension benefits, Kelly’s work status and their cash-flow needs will all affect the overall benefit achieved. For that reason, if you’re at all unsure seek personal advice.

Age pension grandfathering pitfalls

One of the potential pitfalls of this strategy is the loss of some or all of your age pension if your super pension is ‘grandfathered’ from the age pension deeming rules, which started on 1 January 2015 (see Age pension: Keeping your super grandfathered).

Let’s look at the example of Delores, a 66-year old retiree and age pension recipient, with a $235,000 super account. She takes the minimum super pension – $11,750 each year – but has no income for the 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. as the ‘deductible amount’ calculated under the old rules (see Super and the age pension: How the tests work) exceeds it.

Delores has one adult son and her super account is entirely taxable component. If she were to pass away, the death benefit would be subject to around $40,000 in tax, so she decided to implement a re-contribution strategy similar to that which we outlined for Victor (above).

By withdrawing from her current super pension, contributing to a new accumulation account (which is entirely tax-free) and switching this to pension mode, she’s able to collect the same super pension but reduce the potential tax on any death benefit to zero.

But there’s a sting in the tail. The new super pension won’t be grandfathered from the age pension deeming rules. Delores will be ‘deemed’ to earn $7,405 for the purpose of the 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. (see calculation in Table 3), which will cost her around $1,350 of her age pension each year.

There’s a choice for her to make: does she value the certain $1,350 each year, or the potential $40,000 tax saving on her death benefit more highly? Remember she also needs to account for the fact that, if interest rates move higher (increasing deeming rates) the impact on her age pension could be much greater.

Questions?

These case studies cover a number of real-life situations members are likely to face. But there will be other situations where the issues and trade-offs are more complex and the decision on whether to go ahead with a re-contribution strategy more difficult. If you are at all unsure, you should seek personal advice before proceeding, or ask us general questions via Q&A.

 

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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