Proposed $1.6m pension cap opportunities
Curtis Dowel looks at five opportunities planners can consider in the lead up to the possible superannuation changes proposed in the 2016 Federal Budget.
Included in the 2016 Federal Budget were a number of proposals relating to pensions, with the proposed transfer balance cap (pension cap) possibly one of the biggest surprises. With application from 1 July 2017, this cap limits the amount of accumulated superannuation that can be transferred into a tax free pension to $1.6 million.
We've listed five ways to make the most of this pension cap for your clients.
1) Spouse contributions splitting
While an individual has a single pension cap of $1.6 million, couples have the advantage of being able to target each individual's pension cap, or $3.2 million in total.
However, for many couples this may be difficult to achieve for a number of reasons.
Firstly, one partner may have taken time out of the workforce, for example to raise children. This will result in a period of time where no super contributions are made, which can lead to a smaller balance.
It is also common for this spouse to return to work in a part-time capacity, further limiting the contributions being made on their behalf.
Secondly, the proposed lifetime limit on non-concessional contributions (NCCs) will, if enacted, restrict the ability to transfer a large amount of benefits between partners effectively, for example via a re-contribution strategy.
Spouse contribution splitting is an option for couples wishing to equalise their balances and target the combined pension cap.
A spouse contribution split is the process whereby 85 per cent of one spouse's concessional contributions (CCs) is transferred to their spouse's account, effectively by a rollover.
It can generally only be implemented in the following financial year in which the contributions are made and only one split is permitted per financial year.
The receiving spouse must also be under age 65 and have not met a retirement condition of release.
To understand how this strategy can help to manage a couples' combined pension cap, let's look at an example: Faye and Adam. Faye is 55 and has super valued at $875,000. She earns an income of $140,000 and makes super contributions up to the CC cap, which she wants to continue.
Her fund earns 6.72 per cent net of fees but before tax.
Her husband, Adam, also 55, has superannuation valued at $150,000. He earns income of $100,000 and is also making the maximum CCs to this account. His fund also earns 6.72 per cent net of fees but before tax.
Both Faye and Adam intend to retire at age 65.
The effect of spouse contribution splitting for Faye and Adam is quite dramatic.
Without splitting her superannuation, Faye will accumulate super at age 65 of $2,010,055, which will be $10,005 over the value of the indexed pension cap at that time, assuming the consumer price index increases by 2.5 per cent per annum.
By utilising the strategy, her balance at age 65 is $1,648,985 - a reduction of $361,070 and well within the indexed pension cap.
In a similar fashion, Adam's super balance increases from $643,753 to $1,004,823.
So, while their combined total super is unchanged by this strategy, both are now within the pension cap (as shown in the chart below).
An additional benefit of this strategy is that this could provide Faye with capacity to make NCCs, assuming she has not already used her lifetime limit, within the pension cap.
Although not relevant to Faye and Adam as we've assumed they will both contribute to their CC cap each year, the proposed superannuation balance threshold of $500,000 for carry forward of unused CC capacity may be a consideration when deciding to use a spouse contribution splitting strategy.
Indeed, spouse contribution splitting in the opposite direction to that suggested for Faye and Adam may be considered in order to maintain eligibility for carrying forward unused CC capacity.
2) Choose where to draw income from
For those clients with accumulated superannuation in excess of the pension cap and with high income needs, a simple strategy to minimise the drawdown from pension phase may help to maximise the longevity of retirement assets.
Consider Narelle, age 65, who has $2 million in superannuation. Narelle needs $100,000 to fund her lifestyle needs.
If she commences a pension up to the pension cap of $1.6 million, the minimum pension she will be required to draw is $80,000, which is $20,000 short of her requirements.
Assuming she has no other assets, she has two options - she can increase her pension payments to $100,000 or draw the $20,000 shortfall from the amount that remains in accumulation phase.
The table below shows the total portfolio value under these two options, assuming a rate of return of 6.72 per cent after fees but before taxes.
Based on our return assumptions, the preferred strategy is to take the shortfall from accumulation phase and maximise benefits in the tax free pension. Over the long-term, this strategy provides a substantial benefit.
3) Death benefits tax
With the proposed removal of the anti-detriment benefit, greater focus is likely to be placed on death benefit payments, particularly if ultimately paid to adult children.
Unless the beneficiary is a dependant (ordinary meaning) or was in an interdependent relationship with the deceased, adult children will be non-dependants for taxation purposes, with the taxable component being subject to tax at 15 per cent plus Medicare.
The introduction of the pension cap may exacerbate this issue where benefits in excess of the cap are held in accumulation phase.
This is because all investment earnings in accumulation phase are attributed to the taxable component, compared to the proportional attribution to both taxable and tax free components that occurs in pension phase.
Continuing the Narelle example above, the proposed strategy also has potential death benefits tax advantages. Assume that Narelle's benefits consisted of a 50 per cent tax free component at age 65.
By age 85, under the option to draw her income needs in excess of the minimum payment from her accumulation account, the components of her superannuation in our example will be 56.3 per cent taxable component and 43.5 per cent tax free component.
If she takes all of her income requirements from her pension, the components of her benefits at this age are 72.1 per cent taxable and 27.9 per cent tax free.
Based on our assumed returns, the table below shows the net death benefit amount that a non-dependant for tax purposes may receive under the two options:
A further consideration is that the payment of a lump sum death benefit will generally result in the assets within the fund being sold down to pay the benefit.
Generally, the earnings tax exemption continues to apply to pensions following the death of a member.
This is not the case in accumulation phase, where capital gains tax (CGT) will be payable on the realisation of assets, potentially reducing the amount received by beneficiaries - both dependants for tax purposes and non-dependants.
4) Assets held outside super
One of the consequences of the proposed changes is the limited capacity to move funds into the superannuation environment due to the lower CC cap and lifetime NCC limit.
For those unable to contribute further, accumulating capital outside of super may be attractive for a number of reasons.
Firstly, consider accessibility. The super preservation age is currently 56 and is rising to age 60. Having a sum of money outside of super allows those under preservation age access to capital should they need to, for example to retire earlier or repay a mortgage.
Secondly, a considerable level of income can be earned in an individual's name before tax is paid.
The table below shows the tax free thresholds for those under and over age 65 (including relevant offsets).
The level of assets that can be held to produce these levels of assessable income is based on the actual return rates achieved by the assets.
For example, if a 65-year-old was to earn a taxable return (that is, a return that excludes the components of return that are not taxable, for example unrealised capital gains) of 3.5 per cent from their assets, they could hold assets of $922,228 and not pay any tax.
Of course if the return was lower they could hold more assets and vice versa.
However, an important consideration is any growth that the portfolio may achieve, which may then translate to an increase in the taxable income in later years.
So care should be taken when holding assets in personal names, to not create a tax burden in future years.
Finally, there is also the consideration of what happens upon death.
As we saw in point three, the tax payable on superannuation death benefits can be quite substantial when paid to adult children - however the same tax is not applicable for assets held personally, although the cost base of assets are generally inherited by beneficiaries, so an unrealised CGT liability may be passed on.
These issues should also be taken into consideration for those with funds in excess of the pension cap.
5) Choosing which assets to hold in accumulation or pension phase
When looking to commence a pension where the accumulated superannuation balance is greater than $1.6 million or for those with an existing pension balance in excess of this amount, asset selection may be an important issue.
Ideally all assets would be held in pension phase, but the $1.6 million limit means, if the fund adopts a segregated approach to determining the exempt current pension income of the fund, some choices must be made about which assets are held in pension phase and accumulation phase.
There are a number of factors which may impact on the decision.
The goal is to maximise the after tax return on the portfolio as a whole, across both pension and accumulation interests.
i) Long-term return potential of the asset: As a broad principle, greater benefit may be achieved from assets which are likely to produce a high long-term return if they are held in pension phase. Conversely, lower returning assets may be held in accumulation phase, minimising the tax impact.
ii) Return characteristics of the asset: The weighting of expected income returns versus capital gains returns may have some bearing on the decision process. Assets which have moderate capital gain expectations only and no expected annual income, such as gold bullion, may be suitable to hold in accumulation phase, where CGT is effectively 10 per cent if the asset is held for more than 12 months.
iii) Existing unrealised capital gains position: The level of existing unrealised capital gains may influence the decision also. It may be attractive to hold assets with high levels of unrealised capital gains in pension phase. Furthermore, it may be attractive to hold assets which are in an unrealised capital loss position in accumulation phase. A capital loss may be used to offset a capital gain and reduce the otherwise applicable tax liability, or carried forward to future income years to offset capital gains realised later. Assets may be transferred into and out of pension phase from time to time. However, the explanatory memorandum to the amending bill in 1989 provides a sobering warning to self-managed super fund (SMSF) trustees considering transferring assets into pension phase to reduce a CGT liability, stating: "It would be contrary to the intention... for assets to be transferred into the segregated current assets portfolio to avoid the imposition of capital gains tax. The general anti-avoidance provisions of Part IVA... stand as a barrier against any arrangements for asset transfers for capital gains tax avoidance".
Summary points
The 2016 Federal Budget superannuation measures, if enacted, are a significant development in the Australian retirement savings system.
As is usually the case, with change comes opportunity. Financial services professionals have a range of issues to consider and work through with their clients both in the lead up to 1 July 2017, and in future years.
The five opportunities described here are a starting point - more issues may arise depending on a client's personal circumstances.
Curtis Dowel is the senior manager at Macquarie Technical Services.
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