In the current turbulent investment market, many self-managed super fund clients have experienced negative investment returns.
While it is hard to find any silver lining, there are certainly some steps advisers can take now to at least make the best of a bad situation.
This article explores one of the key strategic opportunities available to clients when markets fall — increasing (or at least maximising) the tax-free component (TFC) of their super.
Why is it important?
Now that most clients pay no tax on their superannuation after age 60, it is reasonable to ask why we should spend time increasing a client’s TFC. Some obvious reasons are:
- those aged between 55 and 60 will pay less tax on pension income or lump sums if their TFC increases;
- non-dependant beneficiaries who inherit a client’s superannuation on death pay no tax on the TFC but are taxed on the taxable component.
Perhaps less obvious, increasing the TFC may well provide some hedge against legislative change.
While it is never possible to predict future legislative direction, our long history of ‘grandfathering’ old tax rules makes it unlikely that a government would introduce tax on a client’s TFC in the future, even if tax was reintroduced for the taxable component.
None of these benefits will necessarily have a substantial or long lasting impact on clients (although the estate planning benefits for particular beneficiaries could be very significant).
However, many of the suggestions in this article can be implemented very easily as part of an adviser’s overall superannuation strategy rather than requiring extensive additional work.
The simplest way to explain some of the opportunities available to clients in the current market is to consider a case study.
Case study
Many wealthy superannuants contributed $1 million non-concessional (undeducted) contributions just prior to June 30, 2007.
Consider a case where a client in this position added their $1 million to an existing superannuation balance (fully taxable) of $200,000. The balance at June 30, 2007, was therefore $1.2 million (of which $1 million represented the TFC). However, by June 30, 2009, the balance had fallen to $750,000 (no new contributions were made in 2007-08 or 2008-09).
Now what are the tax components? The starting point for the TFC is the crystallised segment of $1 million. The fact that the balance has dropped to $750,000 means that if the entire amount was withdrawn as a lump sum or used to start a pension, the TFC would be capped at $750,000. The taxable component is everything else — in this case nil.
Consequently, if a $500,000 benefit is taken now — for example, a lump sum is withdrawn or a pension starts — it will consist entirely of a TFC. The $250,000 remaining in accumulation phase will also consist exclusively of a TFC.
What happens in the next few years?
Let’s imagine that during 2009-10 and 2010-11 the client makes concessional contributions and fortunately investment markets improve.
The net result is that the $250,000 accumulation balance grows to $550,000 by June 30, 2011.
The $300,000 growth in the balance has come from investment earnings and concessional contributions.
Hence, our initial assumption might be that this amount forms part of the taxable component of the new balance.
However, the accumulation balance will actually consist of a TFC of $500,000. This is because of the way in which the TFC is calculated while an individual is in the accumulation phase.
We trace the account right back to July 1, 2007, and determine this as follows:
- the $1 million crystallised segment; plus
- nil new non-concessional contributions; less
- $500,000 tax-free component withdrawn/converted to pension in June 2009.
The taxable component is everything else — that is, $50,000 (the full balance of $550,000 less the TFC).
While negative investment returns might reduce the TFC that would be calculated at a particular point in time (the June 30, 2009, value is capped at the value of the total balance), this example demonstrates that a client can effectively ‘carry forward’ the full value of their TFC to utilise if and when their balance subsequently increases.
It is critical to appreciate that any ‘un-utilised’ TFC would be lost if the entire accumulation
balance were to be:
- cashed out as a lump sum;
- rolled over to another fund; or
- converted to pension,
in 2009 in this example (ie, while the balance was still only $750,000).
Let’s make it more complicated
Let’s return to the position at June 30, 2009, outlined above ($250,000 remaining from the original $1.2 million balance). What if our same client had the following additional features at June 30, 2009:
- another superannuation fund (Fund 2) with a balance of $200,000 (all taxable);
- intending to make $50,000 of concessional contributions in the 2009-10 financial year; and
- preferred to consolidate superannuation into one fund.
In total then, let’s say the client has $492,500 immediately after all these transactions:
- the original $250,000 in Fund 1; plus
- an additional $200,000 in Fund 2; plus
- $50,000 ($42,500 after tax) in new concessional contributions.
The precise way in which the superannuation is consolidated will not affect the total amount, but it could have a profound impact on the tax components of that balance.
For example, one approach might be to simply roll the Fund 1 balance into Fund 2 and then add the new contributions (see diagram).
The tax-free component would therefore be:
- nil from the existing Fund 2 balance;
- $250,000 included in the rollover from Fund 1 (it was all TFC at the time); and
- nil from the concessional contributions.
That is, $250,000 in total.
However, a totally different result could be achieved by changing the order of events or consolidating in Fund 1 rather than Fund 2.
Say the client simply consolidated the superannuation in Fund 1. When calculating the TFC in Fund 1, we effectively go right back to July 1, 2007, when the crystallised segment of $1 million was calculated. The TFC after the consolidation would be:
- the original crystallised segment of $1,000,000; less
- $500,000 TFC of the benefit taken in June 2009; plus
- subsequent non-concessional contributions (in this case nil, as all contributions were concessional contributions); and subject to a maximum of the balance at the time, that is, $492,500.
In other words, simply consolidating in Fund 1 rather than Fund 2 means that the TFC is $492,500 rather than $250,000.
Keeping the original Fund 1 superannuation interest ‘alive’ has allowed the client to claw back all of his or her tax-free component and derive almost the full benefit of the original $1 million crystallised segment.
In practice, life is rarely so simple that we have complete discretion over where an individual’s superannuation is consolidated. However, there are plenty of variations on this case study that might assist a client in ‘protecting’ some of the TFC apparently lost due to falls in investment markets.
This same client could, for example, make the concessional contributions to Fund 1 before rolling the combined balance ($292,500, all TFC) to Fund 2. He could even ensure that he left a small amount in Fund 1 and kept making concessional contributions to that fund for the next few years — to slowly claw back the remainder of his TFC.
What if our client converted his whole balance to a pension?
The TFC is determined in the usual way just before the pension starts (ie, looking back to July 1, 2007, and adding/subtracting subsequent contributions/benefits). It is then compared to the client’s balance at the time and expressed as a percentage. From that point, the TFC of any payment (including pension payments, lump sums to beneficiaries on death, rollovers to other funds or back to accumulation phase) is determined by simply applying this percentage to the amount of the payment.
A natural consequence of this system is that once the pension starts, all earnings are effectively shared between the tax-free and taxable components. This is quite different to the fixed dollar TFC system discussed so far in this article and in fact creates its own series of opportunities to maximise a client’s TFC in pension phase. Unfortunately, however, these are beyond the scope of the current article.
Opportunities
What the case study really demonstrates is the way in which the proportioning rules can be harnessed in a falling market to effectively convert money that would ordinarily fall into the taxable component (concessional contributions, earnings) to a TFC while a client is in accumulation phase.
The different treatment for pensions suggests that once clients have taken full advantage of these opportunities, they should consider moving to pension phase while investment markets recover.
Meg Heffron is principal of SMSF administrators Heffron.
