Transitioning our beliefs about super

For so long, all of us have believed that superannuation is for the purpose of providing for our retirement. We told our clients to work hard, put their money into super and when they reached retirement they could have their superannuation as a lump sum or pension.

We considered their reasonable benefits limit (RBL) position, their income needs, and when their plan was settled they drove off into the sunset.

We all know that superannuation is retirement. We had it drilled into our brains by our employers, accountants, dealer groups, fund managers and even the government. We built systems around the idea, spent millions of dollars convincing the public of it and some companies even put the word retire in their name as celebration of it.

The new retirement

Suddenly the government decides there are too many baby boomers about to retire over the next 15 years and the economy can’t afford to lose these highly productive members of society.

So, without consultation, the assistant treasurer comes out and simply gets rid of the retirement barrier and says we can now access our superannuation once we reach our preservation age whether we are working or not.

As a result, an adviser’s life is no longer as we know it. A forced change to all of our beliefs about superannuation and many other things has dramatically occurred.

For example, how can we work out a client’s RBLs if they are still working and contributing to super? How do we know how much of their super to use while they are working? Should we split any of their super into their spouse’s account or the other way around if they are the older spouse? What sort of income stream should we choose with the new allocated and market linked pensions that effectively carry on for 100 years of age or more? Are interest deduction strategies after age 55 effective anymore? The list goes on and on.

I know things change, but this is too much for my small brain to cope with. All my beliefs about superannuation have to be thrown out the window and a new set grown and implemented.

Let me show you how things could now look for a typical small business client who is currently working.

Case study

Noel Watson is currently aged 55 and runs a successful car parts company. He has had the company since 1982 and intends on keeping it until the day he dies, or at least until his boys decide to take over in five to seven years.

His salary package from the company is $75,000 gross and his family needs a modest $50,000 net per annum to live on. Both boys currently work in the company as does his wife Brooke.

The company earns another $200,000 in profits per annum, which are generally accumulated in the company. At this stage, the company has $500,000 in undistributed profits and a swag of franking credits.

Noel’s assets comprise of a house valued at $750,000 with no mortgage. He also personally owns the factory his company works out of which is currently valued at $350,000 with a mortgage of $150,000 and an accrued capital gain of $80,000.

The property provides gross rental income of $35,000 per annum. In addition, there is $100,000 in managed imputation funds that have a $40,000 accrued capital gain. The funds pay a fully franked distribution of 4 per cent and this is expected to continue into the future.

Jointly, Noel and Brooke have $100,000 in a cash management trust courtesy of their frugal lifestyle. The income of $4,500 is shared between the two of them.

Finally, Noel has built up $550,000 in a family self-managed super fund (SMSF). Brooke has $200,000 in the fund and receives $40,000 in salary and wages from the company. Brooke is aged 49.

The problems

Noel and his family are set up perfectly in terms of their financial future.

They are achieving their desired lifestyle income easily and like many successful small business owners they are stockpiling their profits in the company.

However, their big headache is tax — not only current income tax but future capital gains tax and excess benefits tax. Consider some of their immediate and future tax problems:

First, Noel is paying PAYE tax on his salary. He also must include the rental income from the lease of the factory to his company — although the company will receive a tax deduction for this rent. The managed funds distributions are tax effective as they come with imputation credits, but income is not what Noel needs at this time. Brooke is in much the same position in terms of salary as Noel and clearly her income is not being utilised but stockpiled in the cash management trust.

Next, Noel is not far off his lump sum RBL and with future contributions and growth on his investments — courtesy of his financial planner — he really has an RBL problem. Super splitting will alleviate this to some extent, but over time that strategy will clog up Brooke’s RBLs.

Under the current structure, the better a financial planner does in terms of investment returns and income the worse the situation gets.

SMSF basic strategies

The ability to access superannuation while we are working provides us with some great strategic tools to help Noel and Brooke.

In a basic SMSF strategy, Noel needs to be set up with a non-commutable allocated/ market-linked pension using the transition to retirement rules immediately. One of the benefits of using the market-linked pension is that it locks into place the higher pension RBL for him, although the downside is that if he retires early he can’t commute it.

We need to maximise the amount of benefits that find their way into Noel’s pension account. At this stage, he has $550,000 in benefits that can be used.

However, the $100,000 sitting in the cash management trust they jointly own can be transferred directly into the fund and Brooke’s portion needs to be contributed to Noel as a spouse contribution.

This will now take Noel’s potential pension benefits to $650,000, with $100,000 representing undeducted contributions. This will get him close to $50,000 of tax-effective pension income should he choose.

Noel and Brooke should salary sacrifice into superannuation as much as possible, getting them into a strong position to retire when their sons take over the business.

Intermediate strategies

The SMSF trustee should then buy the factory with the cash in the fund. As the factory is business real property, the trustee of the fund can acquire it and at the same time not be troubled with the in-house assets test or section 66 of the Superannuation Industry Supervision (SIS) Act 1993.

In terms of ongoing rent, this would be paid to the trustee of the fund and would need to be at market value.

The cash received by Noel for the property —$350,000 — would be used to pay off the mortgage of $150,000 with the remainder being contributed back into the fund as an undeducted contribution.

Now Noel has sold an asset being business real property. The underlying capital gain on the asset is $80,000. However, as the asset is an active asset of Noel’s company he can utilise the small business retirement concessions.

These would see Noel receive the normal 50 per cent CGT relief, a further 50 per cent relief on the remaining capital gain under the small business rules (a total of 75 per cent discount altogether) with any extra being treated as a CGT exempt amount.

So, of the $200,000 paid in, $180,000 are undeducted contributions with $20,000 being CGT exempt.

Noel’s pension account has now increased to $850,000 ensuring that he will easily be able to receive $50,000 net income from the market linked pension or non-commutable allocated pension used in the fund.

Remember, there is now $300,000 of undeducted purchase price that translates into a healthy tax-free deductible amount and because he is aged 55 any pension attracts a 15 per cent tax rebate.

The property should be used in part to provide a large part of the income required to fund the pension. The $35,000 of income, which is tax deductible rent from the company, goes into the pension side of the fund and is thus tax free. Much better than the current tax he is paying with the rent coming to him personally.

When the boys take over the business and take over the property lease, the property will continue to provide the fund with a good income-earning asset.

Advanced strategies

If we managed to get Noel to salary sacrifice his entire salary for the year — which may prove hard this late in the year but certainly in following years — then he may be entitled to claim a personal tax deduction for any contribution under section 82AAT of the Income Tax Assessment Act (ITAA) 1936.

This is a result of the operation of section 82AAS(3), which enables a person who has no assessable income from an employer who contributes to the fund to claim a tax deduction in their own right — often known as the 10 per cent rule.

If we can claim a personal tax deduction, then we can transfer the $100,000 of managed funds currently owned by Noel into the fund as an in-specie contribution. These are exempt from the acquisition of asset rules under section 66 of the SIS Act 1993.

Any capital gains — currently $40,000 — on the managed funds is to be discounted to $20,000.

The remaining $20,000 can then be reduced by the section 82AAT deduction.

This means that the $100,000 of contributions made into the fund would be $80,000 of undeducted contributions and $20,000 of ordinary superannuation contributions.

The benefits Noel now has for pension purposes has grown to $950,000 and will easily provide Noel and Brooke with the $50,000 of net income required.

The managed funds loaded up with the imputation credits are now on the pension side of the fund. No tax, but more importantly the trustee of the fund can use these credits to reduce the contributions tax payable on the salary sacrifice and section 82AAT contributions.

The investment strategy for the pension side of the fund should concentrate on managed funds or equities with strong imputation credits and income — such as bank stocks.

This will top up the pension account with income to allow the trustee to pay out Noel’s pension while reducing the impact of contributions tax.

For example $600,000 in imputation investments paying a 4 per cent fully franked distribution of $24,000 will have $10,286 of imputation credits. This will shield $68,574 of taxable contributions.

In future years, the retained profits in the company can be distributed to Noel and Brooke and contributed into the fund for either one’s accounts. This is where ongoing RBL management becomes important. The dividends will have imputation credits attached.

An investigation will need to be conducted to determine whether the credits are sufficient to pay the tax payable on the dividends — particularly if Noel is taking a tax-effective pension.

An alternative may be to use section 82AAT for Noel and Brooke — if she is salary sacrificing — to make a tax-deductible contribution with the cash received from the company dividends.

Although there may not be any tax payable as a result of the deduction, any credits may be used to get rid of any tax on Noel’s pension and if there is any excess then the credits are refundable.

Post inheritance

By the time the boys take over the business, Noel and Brooke should have cleared out all retained profits in the business and be set up with strong accumulation accounts in their SMSF for the purposes of paying retirement pensions. These would run alongside Noel’s transition to retirement pension.

The boys can then take over the business with their parents established in pensions effectively for the rest of their lives. Noel and Brooke can then work toward transferring the shares in the company to the boys at the lowest possible price.

Of course the above strategies will take some significant behind the scenes work particularly in terms of documentation and finding an SMSF trust deed that allows all of their strategies.

In addition, careful consideration needs to be given to RBL management and also Part IVA of the ITAA, however, experienced players should not be perturbed by either.

The upshot of this client scenario is that there are now so many options for small business owners and executives that it is hard to know where to start.

The old days of only looking after a client when they retire are well and truly gone.

Grant Abbott is principal of SMSF Strategies. He can be contacted on grantlvc@bigpond.net.au.