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Financial planning, Investment and Self Managed Super Fund Article
Margin Lending vs Excess Benefit Funding
By Tony Negline
1st February 2005
This article may be out of date.
Just how tax effective is funding excess super benefits?
This is a very good question when you know that the contributions and their growth are almost certainly going to produce a benefit which exceeds a person’s lump sum or pension Reasonable Benefit Limit (RBL).
Recently I came across some research by St.George Margin Lending. The research is in the form of a case study.
Here we present this case study in its entirety (reproduced with permission). I will then conclude with some further observations of my own.
This strategy has twin objectives:
- The first is to show how advisers can assist their property-owning clients to purchase further investment property
- Secondly this strategy discusses whether gearing may be better for someone who already has an adequate level of super funding, rather than simply generating more excess benefits.
Property investors who are within 10-15 years of retirement often begin to realise that their properties will not generate sufficient retirement income and therefore need to look elsewhere to diversify their assets to improve their income earning potential.
Often property owners intend to sell their own home and retire either in one of their investment properties or in a new property elsewhere…typically by the sea. In some cases they may like to keep their current home as another investment property.
A key issue for people in this circumstance is to ensure that they maintain access to the CGT exemptions for principal place of residence.
The full CGT exemption for the principal place of residence is available when it was your main residence for the whole period of ownership; it was not used to produce income for tax purposes; and the total land surrounding the house must be less than two hectares.
A partial CGT exemption may be available if the home was your main residence for part of the time that you owned it; or the land was used to
produce income for tax purposes; or the house is on more than two hectares of land.
Importantly, if you own more than one house, then only one of those houses can be your main residence for CGT exemption purposes. However, there is an exception to this rule if you move from one main residence to another.
If you acquire a new home before you dispose of your old one, both dwellings are treated as your main residence for up to six months if:
- the old dwelling was your main residence for a continuous period of at least three months in the 12 months before you disposed of it
- you did not use it to produce assessable income in any part of that 12 months when it was not your main residence; and
- the new dwelling becomes your main residence.
If you dispose of the old dwelling within six months of acquiring the new one, both dwellings are exempt for the whole period between when you acquire the new one and dispose of the old one.
In some cases you can choose to have a dwelling treated as your main residence even though you no longer live in it. You cannot make this choice for a period before a dwelling first becomes your main residence.
This choice needs to be made only for the income year that the CGT event happens to the dwelling, that is, the year that you enter into a contract to sell it.
If you make this choice, you cannot treat any other dwelling as your main residence for that period except for a limited time if you are changing main residences.
If you do not use it to produce income, you can treat the dwelling as your main residence for an unlimited period after you cease living in it.
If you do use it to produce income, you can choose to treat it as your main residence for up to six years after you cease living in it. If, as a result of you making this choice the dwelling is fully exempt, the ‘home first used to produce income’ rule does not apply.
If you are absent more than once during the period you own the home, the six-year maximum period that you can treat it as your main residence while you use it to produce income applies separately to each period of absence.
A good summary of these exemptions is found on the ATO website: www.atcbiz.com.au/index.php?d=zb3x
Super funding issues
Whether or not to deliberately fund benefits greater than a person’s RBL has always been a conundrum for advisers.
The following issues have always caused confusion:
- Super contributions are taxed on the way into the fund (twice for a high income earner who has to pay the super surcharge)
- Lump sum withdrawals of excess benefits are taxed at 48.5% (although the government recently introduced a tax rate of 39.5% of the Post June 1983 portion of an excess benefit)
- Any income paid from a non-rebateable pension (that is a pension which is not eligible for the 15% rebate) is probably going to be taxed at the highest marginal rate
- In the next few years the favourable RBL assessment of lifetime pensions is likely to be removed, meaning that funding for this benefit over the longer term is probably not a valid strategy. (We will ignore the current debate about whether these types of benefits will even be available in Self Managed Super Funds after June 2005.)
Questions to ask?
- Do you own any shares or managed funds? If so, to what value?
- What stocks are involved?
- Are you thinking of moving away from your home into another place just before you retire or not longer after you retire?
- How long will you keep your current home?
- Do you already own an investment property(ies) or will you diversify by increasing your share/managed fund portfolio?
- Are you looking to reduce debt?
- If you could be assisted in gaining financing without using your property as security, would you be interested?
- What is the estimated borrowing you would require?
- What is the current level of super assets that you have?
- Do you expect that with average investment performance in your super fund you will have assets greater than your pension RBL?
The Biggs, David (aged 50) and Margaret (aged 48), live in Brisbane. They own their own home which they purchased in 1992 for $120,000. It is now valued at $560,000. There is no debt on this property.
They own another investment property which is 90% geared. It is in a good location and actually positively geared. Their family home acts as security for this borrowing. The property is worth $300,000 – debt is $270,000.
David is confident that his employer will agree to him retiring slowly. He plans to begin the winding down of his work commitments in 10 years time – when he turns 60.
He wants to work semi full-time (that is, four days per week). He will do this for 18 months. After that period he will work for three days per week for 18 months and two days per week for another 18 months. Once that is complete he will return to work on an as needed basis, but no more than two days per week.
David still belongs to his employer’s super scheme which is an accumulation style fund. Based on reasonable assumptions he will have total super assets greater than his pension RBL when he retires. They have expressed an interest in setting up a Self Managed Super Fund.
He and Margaret want to retire to the Sunshine Coast. They would like to spend $500,000 on this property. They want to buy their house now because they are concerned about further large appreciation in property prices in that area.
Before they fully retire they intend to use this new house as another investment property. Their Brisbane property will continue to be used as their home until David is fully retired and will then be sold.
They own a share portfolio of listed shares which is currently valued at $80,000 and is generating about 5% dividend yield fully franked. They have acquired this share portfolio via the many IPOs that have taken place over the last 15 years. Thus the share portfolio is made up of Commonwealth Bank, Qantas, NRMA, AMP, Woolworths and Telstra.
Once they have retired they will sell their Brisbane home and use those proceeds to reduce debt on their retirement home on the Sunshine Coast.
Once they have worked out their budget and their expected cash flows, they expect to have $20,000 of David’s salary left over. Do they contribute this to super for the next 15 years and create a huge excess benefit, or do they take this as PAYG income and contribute the net amount into a gearing plan?
Case study solution
- Transfer shares to margin loan and extract $55,000 cash. Dividends and franking credits cover this interest expense (which is deductible because it is for an investment purpose)
- Use the extracted cash to pay for the purchase of the new home
- Extract $50,000 equity in their current home to also use in the purchase of their new home. (Again this interest is deductible.)
- Assume that the new home costs $530,000. They borrow $460,000 on an interest only basis at 6.75% for 10 years to purchase this house. Total borrowing per annum is $31,050
- In 15 years time their Brisbane home will be worth about $1.5m (assuming an 8% compound return on Brisbane real estate). When this property is sold they will use $460,000 of this to eliminate the debt on their Sunshine Coast home
- The Sunshine Coast home will also be worth about $1.5m – CGT payable when this house is sold can be expected to be about $250,000
- David and Margaret’s adviser runs the numbers to compare whether it is better to over-fund their super or contribute to a gearing plan.
Effectively their adviser will be comparing salary sacrificing $20,000 per annum (indexed by 4% per annum) for 15 years, or contributing $10,300 into a margin lending arrangement – $20,000 taxed at 48.5% (again indexed by 4% per annum) for 20 years.
- All contributions (whether to the gearing plan or superannuation) are made quarterly in arrears
- Total returns in superannuation is 7% with 40% of that return being franked. Returns in the gearing strategy are assumed to be 3% income and 4% capital growth distributed each year
- All super contributions are subject to upfront contributions tax and the full super surcharge (2004/05 – 12.5%, 2005/06 and later years – 10%)
- Upon retirement, the after CGT proceeds of the gearing plan are contributed into super as an undeducted contribution and used to commence an allocated pension. The income generated from this pension is assumed to be taxed at 48.5% less the 15% rebate
- Gearing is assumed to be 50%
- The additional super contributions are used to purchase an allocated pension. The income from this pension is assumed to be taxed at 48.5%, but because the pension is an excess benefit pension, it doesn’t receive the 15% rebate on each pension payment
- All expenses have been ignored.
There is a 17% benefit increase by using gearing.
The strategy assumes that the super system will remain unchanged. This includes the ability to make undeducted contributions without any restrictions or limitations.
It also includes the same design in allocated pensions (such as deductible amount calculation, minimum income factors, etc.).
By using the gearing strategy, David and Margaret gain the advantage of not losing access to their funds in the same way that they would if the money were to be placed into super.
The taxation of the gearing strategy each year has not been considered. This income tax impact can be minimised by making Margaret the owner of the after tax contributions that are made.
If ever there has been an argument for the elimination of the super surcharge this case study is it.
You can now see why I thought re-producing this case study in full was a good idea.
I have gone back and modeled what the super benefit would look like if the super surcharge was dropped.
- super benefit increases to $569,303
- minimum allocated pension becomes $36,261
- income tax payable on this is $17,587
- net benefit becomes $18,674
- gearing strategy is still ahead, but the gap has narrowed dramatically
- gearing strategy is now only 3.4% higher.
If ever there has been an argument for the elimination of the super surcharge this case study is it.
This raises the possibility of the super surcharge being removed at some future time.
One should never discount the possibility that this will come about.
Before Federal Parliament was prorogued for the 2004 election the Senate accidentally amended some super surcharge legislation in such a way that the surcharge was entirely removed.
This amendment then went back to the House of Representatives. The then Parliamentary Secretary to the Treasurer (Ross Cameron, who lost his seat in the 2004 election) said:
…the government is aware that the amendments do not reflect the Senate’s intention…the Senate has produced an outcome which the government would very greatly prefer to the one which they are going to allow…As an act of good faith…we are going to reject the current amendments and return the bill to the Senate so that it can consider further amendments which will operate to better reflect the Senate’s wishes.
One presumes that Ross Cameron was speaking on behalf of the government. We need to keep reminding it of his comment.
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