By Liam Shorte and Richard Livingston 22 Mar 2015

The three phases of super

As you age, your super goes through different phases. Liam Shorte and Richard Livingston explain the basics.

Snapshot

  • The tax treatment of your super changes as you reach certain (age based) milestones
  • Your investment strategy should also change as you age
  • We identify the key things you need to know and highlight common pitfalls

While no one needs to know all the rules to successfully running an SMSF or making a success of their superannuation, it’s important to have a basic understanding of the three key phases of super and how they work.

As your super moves through the different stages it will affect the tax treatment of your fund and any pension you take. They're not directly related, but your overall investment strategy will also tend to change as your super transitions from one phase to the next.

What are the three phases of super?

Your super lifecycle can be divided into:

  1. Accumulation. This is the longest phase for most (although it depends on how early you start and the age to which you live) and runs from when you start work until you’re in your 50s. This is the stage when you’re contributing to super, not spending it and generally trying to save (accumulate), and earn as much as possible.
  2. Transition to retirement. The transitional phase is the shortest. However, it’s still critically important and many people make mistakes at this point. During the transition to retirement phase, you may be still madly saving, shifting between saving and spending or simply spending; it all depends on your personal circumstances.
  3. Pension. This could also be called the ‘spending phase’. At this point your accumulation is largely done and you’re focusing on preserving your capital, generating income and hopefully spending what you’ve got sustainably.

To these we could add a fourth phase – death – and the topic of estate planning. But this is a complex area that we’ll cover separately.

Let’s take a look at each in turn.

Accumulation

Whether you’re 25 or 50, the key at this stage is saving and investing. Our current super rules allow you to contribute in one of two ways:

  1. 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.. Typically these will include the compulsory super deducted from your pay, voluntary pre-tax (salary packaged) contributions and tax deductible contributions (for self-employed people). 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 subject to an annual cap ($30,000 for most, but $35,000 for those over 49 on 1 July). You can find out more about 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. at the ATO website.
  2. 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.. These are voluntary contributions made without 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. or claiming a tax deduction. Effectively you’re just shifting cash into your super fund. 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. are also subject to an annual cap (of $180,000) although there’s also a 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. which allows you to accelerate three years worth of cap and contribute $540,000 in one hit. You can also find out more about 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. at the ATO website.

You might also save outside of super by, for instance paying off your mortgage or simply holding investments in your own name. Given the restrictions of super (which prevent withdrawals until you reach retirement age) this can be a good approach.

For some people, it might make sense to consider a family (discretionary) trust, private company or both, as an alternative or as an adjunct to a super fund. It’s beyond the scope of this article to discuss when you should contemplate doing that, so let’s return to talking about super.

During the accumulation phase your super fund will be taxed on it’s ordinary income at 15 per cent. 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. get a one third CGTCGT (capital gains tax) is the tax payable on capital gains. Where assets are held 12 months or more, individuals are entitled to a 50% discount when calculating the taxable amount of a capital gain. Super funds are entitled to a 33.33% discount. Where assets are held less than 12 months, capital gains are taxed at normal rates. Note also that some assets are exempt from CGT. discount – if you hold the investment for 12 months or more – so often end up taxed at 10 per cent.

To compensate for the fact you’re effectively getting a tax deduction 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., super funds are also taxed on any 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. they receive. 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 Medicare levy) then you’re effectively saving 24 per cent (39 per cent minus 15 per cent) by contributing to super – a good deal overall (see Making the most out of super for more on this topic).

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. aren’t taxed because you can’t get a tax deduction (or salary package them) when you put the money in. The benefit of 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. is that you pay less tax on the income generated by that money (15 per cent compared to 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.).

Since the caps apply annually (although many would like to see this changed), the trick with contributions is to make them regularly. For example, contributing $30,000 annually will save you more tax (all other things being equal) than contributing $150,000 every five years.

When you’re accumulating, what do you need to think about on the investing side?

The most important thing to remember when you’re an accumulator is that you’ve got time and the power of compound interest on your side. If you’re 25 today, you’ve got several decades before you’ll be spending your super and (hopefully) a lot more saving and contributing to come. This gives you two big advantages over someone who needs to spend their money in the near future.

Firstly, you can afford to absorb volatilityVolatility measures the rate of change of an asset’s price and is a term usually associated with shares. The higher the rate of volatility, the more a share price ‘bounces around’ in the short term.. What do we mean by volatilityVolatility measures the rate of change of an asset’s price and is a term usually associated with shares. The higher the rate of volatility, the more a share price ‘bounces around’ in the short term.? Simply put, it’s the tendency of the prices of riskier assets – like shares and property – to fluctuate up and down a lot.

If you’re investing money you intend to spend tomorrow – or even a few years from now – you may not have an appetite for this level of volatilityVolatility measures the rate of change of an asset’s price and is a term usually associated with shares. The higher the rate of volatility, the more a share price ‘bounces around’ in the short term. risk. This forces you to invest a portion of your savings into investments which repay a fixed dollar amount on a locked in date – for instance term deposits and bonds.

But if your investment horizon is ten to thirty years, the daily machinations of the share or property markets shouldn’t keep you awake at night worrying. All that matters is growing your purchasing power and you can’t do that by investing in term deposits.

The other main benefit accumulators have is the ability to earn a liquidity premiumThe premium (in return, or margin) required by investors to buy a security that cannot be easily or readily converted to cash. , the higher return available on assets that can’t be sold (liquidated) quickly. Again, these tend to be assets like shares, property and infrastructure but also private equity, venture capital and other unlisted equity investments.

Cash and term deposits are good when the money needs to be spent, when investment valuations are excessive, or as a ‘reserve’ to capitalise quickly on short-term opportunities. But long term they usually don’t pay a high enough return to protect your savings from potentially going backwards due to 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)..

It’s important to remember that central bank policy (in our case, the Reserve Bank of Australia’s) is typically the mortal enemy of conservative savers. The role of central banks the world over is to keep interest rates as low as possible whilst producing a little bit of 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). (so long as they don’t let it get out of control).

That’s not a major issue when you’re spending the money – you can’t earn interest on spent cash. But it’s a major problem for long term wealth accumulation.

If you’re an accumulator running your own SMSF or a member in an external fund, you would usually have a reasonably aggressive asset allocationThe way you spread your portfolio among different types of investments (asset classes). For example, if you had $10,000 to invest you might decide on an asset allocation consisting of 50% term deposits and 50% shares. strategy, with a large percentage in growth assets like shares (including a healthy dose of international shares), infrastructure and property.

Transition to retirement

The ‘transition to retirement’ (TTR) pension is a feature of the super system that typically kicks in when you’re 55, so we’ll discuss this phase in that context. But it’s important to remember that retirement planning is a very personal thing.

Some people might qualify for a TTR under the super rules but still be madly accumulating and investing aggressively, with no plans to retire anytime soon.

You’re allowed to start a 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.. Right now, this age is 55 but going forward it will gradually increase to age 60.

The idea behind TTR pensions is to allow you to reduce your paid working hours (and ‘transition into retirement’) by starting to take your super, so you don’t experience a drop in income. But there’s no actual requirement to reduce your paid working hours, so this is one of those situations where you can have your cake (take your super) and eat it too (continue working).

A TTR pension operates a little differently to a ‘normal’ account based pensionThe 'usual' superannuation pension you receive on retirement. Your account contains an amount from which you can make withdrawals (subject to set minimums). These withdrawals (the pension) are generally tax-free for those over 60. (ABP), which we’ll discuss below. Once 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 are required to take a minimum pension of at least 4 per cent (depending on your age) – like an ABP – but you’re also subject to a maximum (cap) of 10 per cent.

Tax exemption begins

The main benefit of commencing a TTR pension (assuming you don’t need the cash today) is that it shifts your super fund, or super account, into ‘pension mode’. This means you no longer have to pay tax, on anything. Even pre-existing (but unrealised) gains are effectively transported into your own private tax haven. Note though some external (industry and retail) funds will ask you to switch funds when starting a pension, which means crystallising existing gains and having the tax deducted before they pay you. So be sure to check with your fund whether this is going to be an issue.

You can still have a (separate) accumulation account when you’re taking a TTR pension, so you can make contributions and keep your overall super balance topped up. Above all else, starting a TTR pension is about making your super tax exempt.

What about the tax that you have to pay?

The tax on the pension you’re now receiving depends on your age. If you’re under 60, you’re taxed 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. on some of your pension (called the taxable component) but get a credit (offset) equal to 15 per cent of the taxable amount. Once you turn 60, the pension payments are tax free.

The biggest mistake people make around transition to retirement is not starting a TTR pension as soon as they’re entitled to. However, not everyone will be better off shifting their SMSF into pension mode. For instance, those on the top 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., contributing the maximum concessional contributionThe '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., but with a relatively low balance, may in some cases be better off not being forced to take a super pension.

Another ‘exception’ is where shifting to a TTR pension might affect Centrelink entitlements. The common example is where someone on an Age Pension (or entitled to Commonwealth Seniors Health Card) has a younger spouse, since the accumulation accounts of those under 65 are excluded from 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 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..

You should always check the impact of any strategy on you, or your partner’s Centrelink entitlements. But for most people it’s a mistake not to make your super ‘tax exempt’ as soon as you’re entitled to.

The other mistakes people make as they head into retirement are not making any changes to their investment strategy, or being too heavy handed about the changes they do make.

As you age, and get closer to the point when you’ll retire (and start spending you’re savings) your asset allocationThe way you spread your portfolio among different types of investments (asset classes). For example, if you had $10,000 to invest you might decide on an asset allocation consisting of 50% term deposits and 50% shares. should gradually become more conservative (for example, less shares, more term deposits). You can’t afford to take as much volatilityVolatility measures the rate of change of an asset’s price and is a term usually associated with shares. The higher the rate of volatility, the more a share price ‘bounces around’ in the short term. risk, or hold as many illiquid‘Illiquid’ is the opposite of liquid. An investment is ‘illiquid’ if it can’t be sold quickly at a reasonable price (eg property) and an investor is said to be ‘illiquid’ where they have no or little cash (or other liquid assets) on hand or their portfolio is largely funded with debt. investments, because soon you’re going to be spending some of your money.

It’s important to make this shift, but not to go overboard. In 2008, many people who retired post-GFC were forced to sell investments at historically low prices because they needed the money. This meant they weren’t able to participate in the subsequent recovery.

They should have shifted some money to cash and term deposits beforehand, giving them money to spend in the initial retirement years, but not the whole lot. If they’d had a sufficiently diversified share portfolio and didn’t need to spend the money over the last six years, then fluctuating prices in between wouldn’t have negatively affected them. In fact, with interest rates falling, a big shift to term deposits in 2008 might have been just as damaging for some investors as remaining heavily exposed to shares.

Pension

This stage might also be called the ‘withdrawal phase’ since you’ve stopped accumulating and started withdrawing your savings to spend.

Under the super rules, the full pension phase (the point where you can take an ABP) kicks in when you meet a ‘condition of release’. The main conditions of release are:

  • retiring from the workforce at or after 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. (between 55 and 60)
  • leaving one paid job (from a contributing employer) after age 60
  • reaching age 65

You super can also be accessed on death or certain ‘partial early release’ conditions (more details if you wish to read more).

At this point you can start taking an ABP (account based pensionThe 'usual' superannuation pension you receive on retirement. Your account contains an amount from which you can make withdrawals (subject to set minimums). These withdrawals (the pension) are generally tax-free for those over 60.), which differs from a transition to retirement pension in two respects. Firstly, the amount you can withdraw is unlimited (although the same minimums still apply). Secondly, you can commute part of an ABP to a lump sum withdrawal.

If you’re already taking a TTR pension, starting an ABP doesn’t change the tax treatment of your super fund (since it’s already tax exempt). But if you aren’t, commencing an ABP will see it freed from income tax (see above). For anyone commencing an ABP over age 60, the pension is automatically tax free. However, if you’re under 60 and wish to commence an ABP it will be taxed in the same way as a TTR (see above).

The minimum pension (withdrawal) rules become a factor during this stage since they increase over time. For instance, if you’re 82, your annual withdrawals must be at least 7 per cent of your account balance.

On the investing front, age (and the need to spend your money) should see you become increasingly conservative, with cash, term deposits and bonds more of a focus. But it’s important not to become too conservative since a portion of your savings still has to last, and maintain its purchasing power for a very long time. Australians are living longer and there’s a 10 per cent chance at least one member of a retired couple will live to 104.

As we said above, at no point is a seismic shift necessary in your asset allocationThe way you spread your portfolio among different types of investments (asset classes). For example, if you had $10,000 to invest you might decide on an asset allocation consisting of 50% term deposits and 50% shares., nor do you need to suddenly switch all your riskier shareholdings into blue chip stocksA colloquial term for listed shares in companies that are large and have been around for many years. Typically they'll be a household name, like Woolworths. and property trusts. If you plan on retiring at age 65 and start out with an asset allocationThe way you spread your portfolio among different types of investments (asset classes). For example, if you had $10,000 to invest you might decide on an asset allocation consisting of 50% term deposits and 50% shares. entirely consisting of ASX listed shares and managed share funds, you might consider shifting 20 per cent into a bond fundA fund (unit trust) which invests in a portfolio of underlying bonds. Bond funds can be either actively managed (where the manager aims to hold bonds it thinks will outperform the broader market) or index tracking (where the manager simply buys bonds that closely match one of the major bond market indices). when you’re 55. By age 60, you might consider putting 10 per cent into term deposits and building up another 10 per cent in an online savings account, plus some more in the bond fundA fund (unit trust) which invests in a portfolio of underlying bonds. Bond funds can be either actively managed (where the manager aims to hold bonds it thinks will outperform the broader market) or index tracking (where the manager simply buys bonds that closely match one of the major bond market indices)., just before you retire.

That’s not investment advice, it’s just one suggestion to get you into the mindset. Your actual asset allocationThe way you spread your portfolio among different types of investments (asset classes). For example, if you had $10,000 to invest you might decide on an asset allocation consisting of 50% term deposits and 50% shares. (and how much you need in savings accounts and short term deposits) is a very personal decision, and will be heavily influenced by any forthcoming spending.

Got it?

While it’s best to leave the minutiae of the super rules to your adviser, accountant or administrator you should have a basic understanding of how your super changes, when you need to seek their counsel and why.

During the accumulation phase you can go on merrily investing (over the longer term) while being mindful of the super options at ages 55, 60 and 65 and the need to gradually change your investment strategy. This basic knowledge could save or make you a lot of money.


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.

All Eviser content is covered by our Terms and Conditions.