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Self Managed Super Fund (SMSF) Article
What benefits from tax reform?

By Tony Negline.

This article may be out of date.

8th February 2006

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The idea of the government reducing superannuation tax has recently been front page news.

Everyone seems to have an opinion on the topic.  Unfortunately there seems to have be a misunderstanding about how super funds are taxed.

It is commonly thought that superannuation funds are taxed at three stages – when contributions are made to a super fund, on fund earnings including realised capital gains and when money is withdrawn.  In reality the first two stages are actually joined together.

Since the mid to late 1980s the government has played a twin game with super.  On the one hand it has made super compulsory for employees and also encourages us to voluntarily invest in super.  The purpose of these measures is to reduce reliance on the government aged pension because of the pressure created by population aging.  To make this policy work super investments are locked away until retirement.  As compensation the government taxes super more lightly than other investment structures and provides tax concessions for super contributions.  This year the government estimated that those concessions cost it $14 billion.

On the other hand the government says it can't afford to give unlimited concessions to superannuation.  It limits tax deductions for super contribution and penalises an investor who accumulates too much money in the super system via the Reasonable Benefit Limits (RBL).  Also the aged pension is reduced for investors who have non-family home assets above certain thresholds.

When super fund taxation was introduced in 1988 the government provided a rebate to income payments for super fund pensions that were deemed to be within a person's RBL.  The maximum rebate is 15%.  It is set at this rate to “compensate superannuation pensioners for the 15 per cent contributions tax”.

Peter Costello said recently that if the government were to reduce super fund tax it would have to reduce the 15% rebate.  How powerful is this rebate?  Last year over 315,000 taxpayers received over $600 million in the rebate – or an average of about $2,000 each.

But what is better for funding retirement benefits, no super fund taxes and no pension rebate, the current regime or a something in the middle?

Here is a simple test looking at four different options.  A super investor has 30 years to retire.  Each year their employer will contribute $5,000 to super (approximately the compulsory super an average wage earner would receive).  We will assume that this contribution increases each year by 4% because of salary increases.  We will also assume that the fund earns 8% throughout after all fees and charges and that 70% of fund assets are invested in Australian shares paying fully franked dividends.  We'll ignore any Reasonable Benefit Limit issues.  This mythical super fund also doesn't provide any insurances.

Option one: no contributions or earnings tax and no rebate on pension payments.  We will assume that the fund receives any franking credits.  After thirty years our investor would have $1.076 million.  For a 65 year old the minimum allocated pension in the first year would be $60,790 before tax.  After paying income tax on those pension payments the person would receive $46,690.  (The average tax rate on this income is therefore 23%.)

Option two is no tax on contributions, 15% tax on fund earnings and no 15% rebate on pension payments.  Under this scenario the investor would receive $856,000.  This produces a minimum allocated pension for a 65 year old of $48,360.  After income tax this figure is reduced to $37,990 which means the average tax rate is 21%.

Option three is 15% tax on contributions, no fund earnings tax and the 15% rebate is available.  Under this scenario the investor would receive $923,600.  This produces a minimum allocated pension for a 65 year old of $52,180.  After income tax this figure is reduced to $48,493 which means the average tax rate is 7%.  (If the 15% rebate was not paid then the net of tax income would reduce to $40,670.)

Option four is the current system – tax on contributions and earnings – including the 15% rebate.  This produces $733,800 in super assets for the member.  For a 65 year old, the minimum allocated pension would be $41,460.  The net of tax income is reduced to $39,380 or an average tax rate of 5%.

In all the above options we have assumed that the fund has received the benefits of any underlying franking credits.

The above modeling shows that the no super fund tax structure produces 19% more retirement income – or about $140 a week more – than the current tax system.  This big difference applies to someone on average earnings not to someone who is 'rich'.

The government will argue that it cannot afford to eliminate all upfront taxes on super.  It would be very concerned that no super taxes would drive too much money into the structure (which is probably right given our high marginal tax rates).  Perhaps it could reduce super taxes by introducing some unpalatable options such as severely limiting access to retirement lump sums.  If the 15% rebate on retirement income were removed, the current batch of retirees would have the be compensated.

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