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Self Managed Super Fund (SMSF) Article
Better Super and Withdrawing & Re-contributing
By Tony Negline.
This article may be out of date.
21st November 2007
A well known and common superannuation strategy for retirees over the last ten years has been the "withdraw and re-contribute strategy" which seeks to increase the tax efficiency of retirement incomes.
The strategy involves taking a lump sum out of the super system and then re-contributing that money into the same, or another, super fund. In nearly all cases the strategies transactions are conducted either just before, or just after, retirement.
With the advent of the government's super reforms, this strategy takes on some new and important aspects. Particular care also needs to be taken if you want to do this strategy in a small super fund.
The principal purpose of investors aged under 60 who want to use "withdraw and re-contribute" will be to get more tax-free money out of their pension. To understand how this occurs some important background is essential.
Each super fund member's benefit is split between tax-free and taxable components. The more proportion of each pension payment that is made up of tax-free components, the less income tax that will be paid. These components are worked out on 30 June 2007.
For example, Betty Smith is aged 58 and just retired. She has $400,000 in super benefits. Twenty percent ($80,000) of this benefit is tax-free component; the balance is taxable component.
She withdraws $175,000 from her super benefits as a lump sum. 20% of this ($35,000) will be tax-free; the balance ($140,000) will be taxable. Under the old super rules Betty might have been able to withdraw only the taxable component. The new super rules do not allow this.
As Betty is aged between 55 and 60 she is able to access her lifetime tax-free limit for the taxable component of $140,000. Therefore this whole $175,000 is tax-free.
She now takes this lump sum and contributes it back into her super fund as an undeducted contribution. Her tax-free benefit now increases to $220,000 or 55%. This means that 55% of any withdrawals will always be tax-free when paid as a pension or lump sum.
The taxable component portion of pensions paid to people aged between 55 and under 60 are subject to normal income rates less a 15% rebate. Therefore the smaller the proportion of a benefit that is taxable component the smaller the income tax bill.
One big problem for people under 60 is accessing their super benefits as a lump sum in order to do this transaction. This is especially the case when they are still working or still unsure about their future work prospects. Generally in order to access your super benefits as a lump sum before age 60 you need to be able to declare that you have ceased gainful employment and intend to never again work for more than 10 hours per week.
Could Betty have withdrawn all of her super benefits and then re-contribute the after-tax balance into super? This is a complex question and another hurdle that retirees have to think carefully about. Some super advisers take the view that there should only be one withdrawal and then one re-contribution for each taxpayer. Others take a completely different view and argue that clients should be allowed to withdraw whatever they want from the super system.
Regardless of these divergent views within financial planning land the ATO said in 2004 that it is concerned about taking a lump sum out of the super system and then a few hours, perhaps even minutes, later contributing that money back into the super system. In the past some small super fund operators haven't bothered to pay money out of their super fund’s bank account. They simply “take” a lump sum and re-contribute by amending their super fund’s financial accounts. In these situations the ATO has said that Part IVA [the income tax general anti-avoidance rules] would probably apply.
Another issue which Betty and her super fund need to be careful about is the "non-concessional contribution limit". Non-concessional contributions are those contributions that are not claimed as a tax deduction by the contributor. This says that each year the maximum undeducted contribution is $150,000 per annum or, for investors under 65, that amount averaged over 3 years. Betty's $175,000 contribution means that she can only contribute $275,000 over the remaining two financial years.
What about people who are aged 60 or over? All payments from the super system either as a pension or lump sum are tax-free. This is regardless of the tax-free and taxable components of the total super benefits. Is there any point for people in this age bracket taking money out of the super system and then re-contributing?If a retiree wants their super assets to be paid to non-dependants (for example adult children) then the answer is probably yes. Taxable component death benefits paid to non-dependants are taxed at 15%. Tax-free components are always tax-free. Taking money out of the super system in order to increase the size of the tax-free component makes a lot of sense. Investors over 65 wanting to do this need to make sure they satisfy a work test before being allowed to contribute to super. Moreover the tax office have said that it "is very unlikely" it would apply anti-avoidance penalties.
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