By Ben Smythe 17 Mar 2015

Making the most out of super

If you want to save for retirement, superannuation is a good way to do it. Ben Smythe explains why.

Snapshot

  • Superannuation is a structure that allows you to substantially reduce your tax
  • The best results come from starting to contribute early and doing so consistently
  • Contributing to super does come with some restrictions and risks

If you want to live a comfortable retirement, without running the risk of falling back on an age pension that’s becoming increasingly inadequate, you need to maximise your retirement savings. Superannuation is a great way to do this.

What’s so great about super? Put simply, it reduces the amount of tax you have to pay – both on your salary and the income from your investments. Admittedly, super is far from perfect, but for most investors it’s the safest way to generate tax-effective, long-term wealth creation (so long as you do it in the way that was intended), while also compounding the tax savings over years and decades.

Unbeknown to many investors, super is first and foremost a tax structure that allows you to invest in different assets, not an investment in and of itself. Exactly how does super achieve more tax effective outcomes? Let’s look first at the contribution side of things.

Making contributions

If you’re earning a salary, your employer is required to make contributions on your behalf. You can often choose to top these up through ‘salary packagingSalary packaging (also known as 'salary sacrifice') refers to the practice of letting employees choose to take fringe benefits out of their 'pre-tax' income in lieu of salary. Examples of salary packaged items include motor vehicles and superannuation contributions.’, up to the relevant concessional contributions capThe annual cap (for each year ended 30 June) on the amount of concessional (pre-tax or tax deductible) contributions a person is allowed to contribute to super. For more information on cap amounts see the ATO website.. Self-employed people can make cash contributions and claim a deduction in their tax return (again, up to the cap).

These are all types of concessional contributionsThe 'normal' contributions made to your super account. Concessional contributions include compulsory contributions made on your behalf by your employer, voluntary contributions made out of your salary package and cash contributions by self-employed people (who are entitled to a tax deduction for it). Concessional contributions are either made from 'pre-tax' income or are tax deductible. See the ATO website for more information. and the benefit is that the amount contributed is either excluded from your assessable (taxable) income or deductible in your return. Either way, you get the same net result: a reduction in the tax you pay.

Concessional contributionsThe 'normal' contributions made to your super account. Concessional contributions include compulsory contributions made on your behalf by your employer, voluntary contributions made out of your salary package and cash contributions by self-employed people (who are entitled to a tax deduction for it). Concessional contributions are either made from 'pre-tax' income or are tax deductible. See the ATO website for more information. are taxed when they land in the super fund, but they’re only taxed at 15 per cent (unless you’ve got ‘adjusted income’ over $300,000, in which case an additional 15 per cent surcharge is payable). When many people are paying roughly 40 to 50 cents in the dollar in tax, that’s a very large tax saving.

You can also make 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., which are cash contributions that aren’t tax deductible and subject to a separate cap. While they don’t save you tax upfront like concessional contributionsThe 'normal' contributions made to your super account. Concessional contributions include compulsory contributions made on your behalf by your employer, voluntary contributions made out of your salary package and cash contributions by self-employed people (who are entitled to a tax deduction for it). Concessional contributions are either made from 'pre-tax' income or are tax deductible. See the ATO website for more information. (and not taxed in the hands of the fund) they’re worthwhile since you save tax on the ongoing income.

They tend to be most attractive to those people later in life who’ve got surplus cash to invest (rather than those in the earlier stages of building their super). For the remainder of this article we’ll focus on concessional contributionsThe 'normal' contributions made to your super account. Concessional contributions include compulsory contributions made on your behalf by your employer, voluntary contributions made out of your salary package and cash contributions by self-employed people (who are entitled to a tax deduction for it). Concessional contributions are either made from 'pre-tax' income or are tax deductible. See the ATO website for more information..

Taxation of super funds

Super funds not only get a lower tax (15 per cent) tax rate on income that’s contributed to super, they also pay a lower rate on their ongoing income and 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.. Ordinary income is taxed at 15 per cent and 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. (on assets held for more than 12 months) are reduced by a third and effectively only taxed at 10 per cent.

This means in addition to saving tax upfront on your concessional contributionsThe 'normal' contributions made to your super account. Concessional contributions include compulsory contributions made on your behalf by your employer, voluntary contributions made out of your salary package and cash contributions by self-employed people (who are entitled to a tax deduction for it). Concessional contributions are either made from 'pre-tax' income or are tax deductible. See the ATO website for more information., you also save tax every successive year on the income the contributions generated. Over the long-term, this really adds up.

An example of the benefits

Let’s walk through a simple example. Assume you’ve got $10,000 of pre-tax income you can choose to take as salary, or package as a super contribution. If you’re on the second highest 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. (39 per cent, including 2 per cent Medicare levy) then you’d get $6,100 of cash. Alternatively, your super fund would end up with $8,500 after paying 15 per cent tax on the contribution (see Table 1).

Let’s assume you do that year in, year out, for thirty years and continuously use the money to buy an investment that returns 8 per cent annually (a 50/50 mix of income and capital growth).

The results are shown in Chart 1. Contributing to super rather than taking salary means you end up with almost $900,000 rather than $500,000.

Investing an extra 23 per cent each year, while also paying less tax on the income and 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., is a powerful combination. Note also that we’ve done these calculations in real terms (that is, using today’s dollars). If we incorporated inflationThe gradual decline in the purchasing power of money over time. Alternatively, the general rate at which prices increase over time. In Australia inflation is typically measure by the Consumer Price Index (CPI). (or used higher rates of return or individual tax rate) the difference would be even greater.

What happens if we repeat the exercise but, in the ‘super’ example, only start contributing in the second decade (Chart 2)? The difference is still huge – you’ll end up with just over $200,000 more – but you can see that delaying the start of your super contributions really hurts the end result.

Unfortunately, as super contributions are subject to an annual cap – which can’t be rolled forward for future use – it’s very difficult to catch up further down the track. The best results are obtained by contributing early and consistently.

Looking at our example from a different perspective, to get the same results taking salary (instead of contributing to super) you’d need to generate an additional 4 per cent return annually on your investments (assuming the same mix of income and growth). Investors will pay thousands in fees, buy high-risk products and fly interstate to real estate seminars in an attempt to generate that sort of extra return. Making the most out of the super system is a great way to boost your savings without taking on extra risk.

What’s the catch?

Nothing in life comes free, including superannuation tax benefits. The catch with super is that you have to wait until you can access your money and there are (limited) restrictions on what you can do with it before you reach 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. (which currently ranges between 55 age 60, depending on your birth date).

If you have an SMSF, the main constraints relate to property and more alternative investments like art and collectibles. You can’t sell residential property to your fund, nor can you or family members use property it owns. Borrowing to buy property comes with extra hoops to jump through, resulting in higher costs. For example, art and collectibles come with special rules around storage and valuation.

Most people are unlikely to see these as creating too much of a constraint. Most people tend to see art and collecting as a hobby rather than a retirement saving strategy. And most Australians already have enough property exposure without needing to put their entire super balance into a leveraged residential property investment. If anything, these rules help to keep super investors on a sensible investing path.

Investors in retail and industry funds are more constrained in their investment choices. If you’re in one of these funds, you can only invest in the options presented to you. Some funds, like AustralianSuper, offer a broad range of choices, including picking your own direct shares and index fundsFunds which simply aim to track the performance of a major index for a particular asset class. For instance, an Australian share index fund might track the ASX 200 index. The benefit of index funds is that they are typically low cost., but you won’t be able to invest in property or other real assets, unlisted funds or get the highest retail term deposit rates.

Of course, the big catch with super is that you have to wait for your money. But if you’re trying to force yourself to save for the long term, that’s probably a good thing. Under the current rules, everyone can access their super at age 65 and it’s possible to access it between the ages of 55 and 65 if you can comply with the various rules that govern earlier access.

Of course, these rules might change and that’s one of the risks of super. Politicians of all persuasions tend to fiddle with the rules governing super and we expect them to get tighter going forward. But we don’t expect super to stop being an attractive, risk-free way to generate extra wealth.

But don’t go all-in on super. It can be a good idea to keep some assets outside of super as an emergency fund and to guard against an increase in the age at which you can access it. For instance, if you’re in your forties today there’s a chance that, by the time you get to 65, the age at which you can get unrestricted access has bumped up to 70.

It might also not be a good idea to contribute the maximum to super if it could leave you struggling to pay the mortgage or other debts in your own name. This strategy might look good on a computer spreadsheet but it brings the added risk of debt stress and bankruptcy.

Making the most of super

To get the best results out of super you need to start using up your annual concessional contributions capThe annual cap (for each year ended 30 June) on the amount of concessional (pre-tax or tax deductible) contributions a person is allowed to contribute to super. For more information on cap amounts see the ATO website. as early as possible, and keep doing so consistently. Getting the most out of the superannuation tax benefits gives you a big head start to a comfortable retirement. Don’t sacrifice it lightly.

Ben Smythe is a principal of Smythe Financial Management Pty Ltd (www.smythefm.com.au), a corporate authorised representative of Financial Professional Partners Pty Ltd (AFSL 466050). 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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