How proposed super and pension changes could hurt your SMSF

On April 5, the federal government announced a number changes to superannuation. The main change is the proposed new tax on pension earnings that exceed $100,000 per member per financial year.

Assuming the proposed changes ever become law (and this also assumes the Labor government is re-elected in September with the requisite majority), the changes are likely to have a significant impact on certain super fund members. This article discusses the practical implications of these proposals with a focus on SMSFs.

How does it work?

Under the proposed changes, earnings on assets supporting pensions that exceed $100,000 per member per financial year will be taxed at 15%. Earnings below this threshold will remain tax free. This change is anticipated to have effect from July 1, 2014. Importantly, the $100,000 threshold is proposed to:

• apply in respect of each member (and not the fund as a whole);
• be an annual limit reflective of taxable income as determined under existing tax rules; and
• be indexed to CPI in $10,000 increments.

Example A

Consider Mum and Dad, who each have $2,000,000 in their SMSF (i.e., $4,000,000 in total split 50/50). Both Mum and Dad are receiving a pension and the SMSF is fully in ‘pension mode’. What are the implications if the SMSF generates a 5% return and a 10% return?

Tax payable if the SMSF generates a 5% return

• $200,000 of total pension earnings have been generated in the fund (i.e., $4,000,000 x 5% = $200,000).
• Remembering that the $100,000 threshold relates to each member and not the fund as a whole, the $100,000 threshold has not been exceeded by either member and therefore – under the proposed new laws – the SMSF tax liability is nil.
• $400,000 of total pension earnings have been generated in the fund (i.e., $4,000,000 x 10% = $400,000).
• There is a 15% tax on earnings exceeding $100,000 for each member.

Tax payable if the SMSF generates a 10% return

Therefore – under the proposed new laws – the SMSF tax liability is $30,000 (i.e., ($200,000 – $100,000) x 15%) x 2).

Example B

Now consider the same facts as above but Dad has $3,000,000 and Mum has $1,000,000 in their SMSF (i.e., $4,000,000 in total split 75/25). Both Mum and Dad are receiving a pension and the SMSF is fully in ‘pension mode’. What are the implications if the SMSF generates a 5% return and a 10% return?

Tax payable if the SMSF generates a 5% return

• Of the $200,000 of total pension earnings, $150,000 relates to Dad and $50,000 to Mum.

Thus, ($150,000 – $100,000) x 15%) = $7500 is the SMSF tax liability in respect of Dad. As Mum is well under the threshold, no tax is paid in respect of her.

Tax payable if the SMSF generates a 10% return

Of the $400,000 of total pension earnings $300,000 relates to Dad and $100,000 to Mum.

Thus, ($300,000 – $100,000) x 15%) = $30,000 is the SMSF tax liability in respect of Dad. As Mum is still under the threshold, no tax is paid in respect of her.

Example C

Consider retirees, Mum and Dad who have a joint total of $5,000,000 in their SMSF. Both Mum and Dad are receiving a pension and the SMSF is fully in ‘pension mode’. We will assume that Mum and Dad have an equal balance (i.e., the fund is split 50/50 between them).

Mum and Dad transfer $1,000,000 into a family trust (FT). Both the SMSF and the FT generate a return of 5%. The associated taxation implications are as follows:

Tax payable on the income generated from the FT

The FT generates earnings of $50,000 (i.e., $1,000,000 x 5%). Assume this income is split equally between Mum and Dad.

The tax free threshold is $18,200 for FY2013. However, no tax is payable on the taxable income of up to $20,542 for FY2013, instead of the usual tax free $18,200 threshold due to the low income tax offset (‘LITO’), which applies for taxpayers earning $37,000 or less. Assume the LITO applies in respect of both Mum and Dad.

Thus, assuming Mum and Dad derive no other taxable income for FY 2013, they will each pay tax of $847 or $1694 combined.

(The above ignores the Seniors and Pensions Tax Offset that can result in an eligible single person on $32,279 of rebate income without paying tax or each partner of a couple on $28,794. We have also ignored the Medicare levy.)

Tax payable at the SMSF level

The SMSF generates earnings of $200,000 (i.e., $4,000,000 x 5%). Assume these earnings are allocated equally between Mum and Dad.

Remembering that the $100,000 threshold relates to each member and not the fund as a whole, the $100,000 threshold has not been exceeded by either member and therefore — under the proposed new laws — the SMSF tax liability is: nil. Total tax payable: $1694

Now consider the implications if Mum and Dad did not transfer the $1,000,000 into their FT.

Tax payable at the SMSF level

The SMSF generates earnings of $250,000 (i.e., $5,000,000 x 5%). Assume these earnings are allocated equally between Mum and Dad.

There is a 15% tax on earnings exceeding $100,000 for each member.

Therefore – under the proposed new laws – the SMSF tax liability is $7500 (i.e., ($125,000 – $100,000) x 15%) x 2). Total tax payable: $7500

Thus, $5806 is saved by investing $1,000,000 via the FT.

The above examples highlight the different outcomes that may result depending on numerous factors such as the total amount in the fund, the rate of return on investments and the split between members in the fund.

Note that, under intense media pressure, the Prime Minister Gillard made a commitment to the electorate well before the April 5, 2013 announcement that there would be no extra tax payable on members aged 60 or older. Interestingly, the proposal is to levy the new pension tax on the super fund trustees.

Practical implications

Arbitrage opportunities – The new pension tax might create arbitrage opportunities whereby investing outside of the super environment may prove more tax efficient for certain members.

This is especially so, as over recent years, the concessions in super have attracted many people contributing most of their investable assets previously held outside of super into the super environment to take advantage of the pension exemption (both within and outside the super fund) when someone attains 60 years and draws a pension.

As you can see from the above example, people will be tempted to move assets outside of super to minimise their tax. This arbitrage opportunity is likely to see a significant shift of assets away from super thereby undermining the amount that will be raised from this new tax.

Accumulation phase – more attractive?

In light of the proposed pension tax, the natural inclination for some might be to move away from pensions. The reason for this being that once pension earnings reach the $100,000 threshold, the tax treatment of a member holding an accumulation versus a pension interest inside super will broadly be the same.

That is, both will be taxed at a maximum 15% at the fund level (with a 10% rate applicable to capital gains on assets held for more than 12 months). However, there can still be significant advantages to maintaining a pension.

Growth generated by a fund in pension phase will accrue in proportion to the tax free and taxable components of the member’s interest, as at the date of the pension’s commencement. This is contrary to an interest in accumulation, where all growth will from part of the taxable component.

Accordingly, one way to maximise the tax free component of an interest is to keep it in pension phase. This might be a worthwhile strategy, despite the proposed new pension tax.

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