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Forward Thinking Magazine : April 2011
7 Option 1: Start a TTR pension with part or all of the super and use the after-tax pension payments (maximum) to pay down home loan. One of the advantages of doing this is that, by starting a pension with all of Nick’s super balance, no fund earnings tax is payable by his SMSF on investment returns. However, whilst he is under age 60 tax is payable on pension payments at the effective rate of 23.5% - this is because all his pension income is assessable at 38.5% (ignoring the 2011/12 flood levy) but attracts a 15% rebate. So, for every $1,000 of pension income withdrawn he pays $235 tax and has $765 left to pay down his home loan. From age 60 the TTR pension income won’t be taxed, so all of it could be used to pay down the home loan. Let’s assume his home loan interest rate throughout the 10 years is 8%. Note that we’re assuming a worst case: ■ all taxable component; and ■ all the payments from the fund will be taxed as pension payments whereas in some cases there will be scope to treat a payment as a lump sum superannuation benefit for tax purposes, in which case the payment may be free of tax if within the client’s lump sum low rate cap. If he uses the pension payments of $1,000 pa that way for the next 10 years he will have paid off some of the outstanding balance of his home loan with each payment and stopped having to pay interest on the amounts paid off. The loan repayments would be $8,825 and the interest savings would be $4,134, meaning a total saving of $12,959. The question is: could he do better by taking an alternative approach? Option 2: Start a TTR pension with part or all of the super and use the after-tax pension payments to make non-concessional contributions back into super. Again, one of the advantages of starting a pension with all of his super balance is that no fund earnings tax is payable by his SMSF on investment returns. Again, however, whilst he is under age 60 tax on pension payments will be at the effective rate of 23.5%. So, again, for every $1,000 of pension income withdrawn he has $765 after tax available to contribute back into super. (As the contributions here are non-concessional they do not generate a tax deduction for Nick but they are not taxed in the SMSF. From age 60 the TTR pension income won’t be taxed and all of it could be used by Nick to make non- concessional contributions.) The non-concessional contributions Nick makes in this way would accumulate in the fund and attract tax free earnings until withdrawal provided the contributions are transferred promptly into pension phase each year. They could be withdrawn when he retires at age 65 tax free and used to reduce his home loan then. So the question is: will the amount they’ve accumulated to be greater than the savings made under Option 1? This boils down to a simple question: will the SMSF’s relevant earnings rate be better or worse than the home loan rate? In Nick’s case it’s assumed the home loan rate was a constant 8% p.a . If Nick assumes the pension account earnings rate (after fees and including the benefit of any franking credits) is better than 8% then he might prefer Option 2. Otherwise, he might prefer Option 1. However, there is a third “do nothing” option which Nick needs to assess as he is only age 55... Option 3: Allow super to accumulate until age 65 without drawing a pension. Under this option, Nick would continue to accumulate his super balance without receiving a pension, then he could withdraw tax free benefits to pay down his home loan at age 65. Nick’s SMSF would pay tax at a maximum effective rate of 15% on earnings on his account, which would be a disadvantage as compared to Options 1 and 2. However, there would be no pension withdrawals reducing the account balance before age 65 and, in particular, unlike Options 1 or 2 there would be no tax paid on pension withdrawals prior to age 60. Indeed, even if Nick assumes that the home loan interest rate is going to be higher than the SMSF investment earnings rate, it is still quite possible that Option 3 will be better for him because it doesn’t incur any pension payment tax before age 60. For a given client tax rate the lines on the graph displayed on page 31 essentially demonstrate where the results under Options 2 and 3 break even having regard to the super account’s initial taxable/tax free component blend and the fund earning rate. In Nick’s case we assume his tax rate is 38.5% and all his starting super balance is made up of taxable component, so a return rate of more than 10.41% would be needed for Option 2 to beat Option 3. Of course, if Nick were already age 60 then Option 3 could never win and the “wealth numbers” contest would simply be between Options 1 and 2, on the basis described above. It’s also worth remembering that many clients aged 55 plus may already have started a TTR pension with all of their super (e.g. for the salary sacrificing purposes described above), in which case the scope to explore Option 3 will be limited to any new contributions made into a fresh accumulation account. Conclusion Proposed changes to the CC cap need to be monitored to assess their impact on existing and prospective TTR pension clients and adjust their strategies where desirable. It is likely that in many cases the appeal of a typical TTR pension / salary sacrifice strategy for a client will be reduced. For these and other clients, however, the appeal of a TTR pension strategy for wealth creation purposes, such as paying off the home loan or funding NCCs, is worth examining. . MAStech