Retirement – Effective retirement income after tax reform

The recent changes in taxation have altered the retirement income streams landscape. JOHN PERRI and ANDREW LOWE examine where the opportunities now lie.

With the ongoing implementation of reforms to the tax system, the time is right to re-evaluate strategies for the provision of retirement incomes.

Advisers and investors should reconsider if pensions and annuities are as effective as they have always been, as well as considering how different structures for providing income stack-up in a post tax reform environment.

Beyond that the issue of how effectively different structures can be used to provide retirement income streams and how pre-retirement planning can significantly increase a client's retirement income, all need to be considered.

In a post tax reform environment, the assets which back income streams, both eligible termination payments (ETP) and privately purchased, will generally continue to be tax exempt.

Prior to July 1, 2000, some income stream providers were subject to a concessional tax regime, with management fees and earnings on shareholder net assets derived by life offices from annuity business not being taxed.

From July 1, 2000, the playing field has been levelled and any life office earnings, less expenses, from shareholder net assets and management fees from this business, will be taxed at the prevailing entity tax rate. GST has also been a consideration, albeit a relatively minor one.

Industry-wide, the combined effect of these changes has generally been small increases in fees on allocated products and a reduction in annuity rates for guaranteed annuities purchased after the announcement of these reforms.

Existing guaranteed annuities are generally not impacted by these reforms.

Importantly, there has been no change to the taxation of income streams at the individual taxpayer level - the availability of tax-free amounts and the 15 per cent rebate remain unchanged.

Superannuation sourced income streams also retain their tax efficient status in the post tax reform environment.

Since July 1, 2000, with reductions in personal income tax rates, the 15 per cent rebate has ensured that no tax, excluding the Medicare levy, is payable on superannuation sourced income streams up to $24,133 per annum.

This is determined in that the gross income and the taxable income per annum is $24,133, as there is no tax-free amount applicable.

At the same time, the tax payable and the 15 per cent tax rebate work out at $3,620, effectively cancelling each other, with a net result of no tax paid and the amount received being $24,133.

As such, a couple can receive up to $48,266 tax free from superannuation sourced income streams.

Further, any undeducted purchase price of an income stream is also returned tax-free over either a fixed term or life expectancy.

The tax reform process has the potential to considerably alter the relative attractiveness of different structures for the provision of an income stream in retirement.

The changes to capital gains tax (CGT), effective from September 21 last year, offer considerable simplification and ease of understanding to investors.

However, these changes contain some inherent bias. These changes provide greater concessions to individual investors, including those investors in collective investment vehicles (CIVs) and superannuation funds, relative to other structures such as trusts and companies.

From a CGT perspective, for assets acquired post December 23, 1999, trusts and companies will be relatively unattractive structures in which to hold growth assets, as there is no discount on gains on assets held in these structures.

Assets acquired prior to this date remain unaffected by these tax reform measures.

The proposed consistent entity tax regime to apply from July 1, 2001, may also impact upon the relative attractiveness of trusts and companies for the provision of retirement incomes. The consistent entity tax regime will not apply to CIVs, such as most public offer unit trusts, as they remain subject to flow through taxation.

Trusts and companies should, however, remain attractive structures to hold income producing investments. It is proposed that trusts will no longer have to distribute all income, or be subject to punitive taxation, and will be able to accumulate income on a tax paid basis, with tax paid at the entity rate of 30 per cent. Also, flexibility over income distribution and other non-tax advantages remain.

Concurrently a number of personal tax reform measures have also had an impact upon the retirement planning process, including reduced personal marginal tax rates, refund of excess imputation credits, CGT reforms and Pay As You Go (PAYG) taxation.

The net result of all these changes means allocated income streams continue to represent a particularly tax efficient structure for the provision of retirement income streams in a post tax reform environment.

It is perhaps timely for advisers to re-evaluate both structures and strategies for the provision of retirement incomes.

<I>John Perri and Andrew Lowe are technical services managers with AMP Life.