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Reforms and your super - Eureka Report article

Reforms and your super

By Scott Francis
May 5, 2010

PORTFOLIO POINT: Three key changes from the Henry tax review will influence investors’ strategies.

The home page of the government's tax reform website emphasises the words “stronger, fairer and simpler”. This is just as well really because “weaker, less fair and more complex” is just not as catchy.

However, investors who look beyond the spin will note that the government's response to the Henry tax review contains a small number of key changes that will affect investors and influence their strategies. Three items in particular are worthy of consideration.

Employer contributions rise to 12% but don’t get complacent

The key change for most investors with superannuation will be the stepped increase in superannuation contributions up to a 12% employer contribution rate in nine years’ time.

The 12% contribution to superannuation is certainly a positive step. The key problem with superannuation as it stands is that it does not provide a person with an adequate sum to fund their retirement. The stepped increase to 12% will start to address that, but only for the very young.

A quick look at the history of superannuation contributions shows that most investors won't receive anywhere near the full benefit. Compulsory employer superannuation contributions were originally introduced by the Keating government in 1992, starting at 3% and rising to 9% by July 2002.

Expressed another way, most employees have received less than eight years of contributions at the current rate of 9%, and it will take another nine years to start receiving contributions at the 12% rate. Indeed, the only people who will receive a lifetime benefit from the 12% contribution level at its fully phased-in level might have been playing sport on the weekend in the under-eights.

By the time they reach 18 they will be the first group to receive contributions at the 12% level. The rest of us will never receive this benefit from superannuation – and need to accept the reality that we will almost certainly have to provide additional savings to top our retirement incomes.

The changing face of superannuation strategies

The proposal that people who are aged over 50 and have less than $500,000 in superannuation can continue to make tax deductible contributions of $50,000 a year provides us with a big clue as to how investors might look to manage their super in the future.

For starters, investors will be more reluctant to make additional contributions to superannuation prior to turning 50 – as this will take them closer to the $500,000 limit and restrict their ability to make tax-deductible contributions of $50,000 a year from that point.

The increase in the Super Guarantee will reduce the need for additional contributions anyway – and many people will simply let the 12% contributions accrue until age 50, focusing on financial planning strategies outside of superannuation including paying off the mortgage, getting rid of debt, investing into a portfolio outside of superannuation or, for the more aggressive, borrowing to invest.

The $500,000 limit will also see an old strategy revived, that of splitting contributions between members of a couple. This is described in this tax office document. Contribution splitting has fallen off the radar recently given that all superannuation withdrawals are tax-free after the age of 60, reducing the need to have equal balances between partners.

This $500,000 limit will again see contributions splitting revived – as couples work out the best strategy to manage superannuation balances to access the $50,000 a year tax deductible contributions to best suit their circumstances.

For example, if one member of a married couple is the higher income earner, they might split their contributions with their spouse so that they keep their individual superannuation balances low enough so that at age 50 they are still in a position to make $50,000 a year of tax effective contributions to their fund. The tax saved each year on money taken as a superannuation contribution (taxed at 15%) compared to income (taxed at up to 45%) might be $15,000 a year on a $50,000 contribution – a significant sum of money for what is simply a reorganisation of cash flow.

The new shape of superannuation, and more generally personal finance strategies, might be summarised as:

  • A focus on employer contributions and non-super investments until the age of 50.
  • The return of income splitting between spouses to take advantage of concessional contribution limits.
  • Renewed focus on building wealth through superannuation for the over 50s until retirement.
Lower company taxes means bigger dividends

A decrease in the company tax rate from 30% to 28% does not sound all that exciting but it will make a difference to the bottom line of many companies. Putting to one side those hit by the additional resource tax, the reduction in company tax will make owning shares more attractive.

Let's have a look at the maths of this. If a company makes a profit of $1 million they pay tax on this profit of $300,000, which leaves them with $700,000 of earnings after tax.

Once the tax is cut to 28%, tax on every $1 million of profit will be $280,000, with $720,000 of earnings after tax. This is effectively an ongoing increase in earnings after tax of nearly 3% – an attractive outcome for shareholders.

If we take this one step further, the flow through to dividends might be even more attractive. Notwithstanding a credit crunch, companies tend to pay about two-thirds of their earnings as dividends while retaining one-third to invest in new projects, pay down debt and pursue other growth opportunities.

Using the same example, if the company keeps a third of the $700,000 to fund new projects ($233,000),that leaves $467,000 to be distributed to shareholders as dividends. Under the 28% company tax regime, earnings after tax increases from $700,000 to $720,000.

Assuming that companies retain the same dollar amount for investment ($233,000), this leaves $487,000 to be distributed to shareholders as a cash dividend. This is an additional $20,000 or a nice boost to cash dividends of 4.3%. After the recent bout of “dividend shrink”, this is something to look forward to!

The bad news is that there will almost certainly be a reduction in franking credits that will eat into some of this increased dividend return. That is because a franking credit is basically a refund of the tax paid at the company level. The good news is that shareholders will still be ahead as the increase in dividend will be greater than the decrease in franking credits.

The government also mentioned in its response that it “will also seek to lower the company tax rate further, as revenue allows”. This would be a further benefit to share investors. However with the budget to be released next week, it’s possible that we haven’t heard all the bad news just yet.

Much has been made in the media of the lack of action made by the government in response to the Henry tax review. But there was still plenty in the proposals the government recommended to stay on top of namely: not relying too heavily on the 12% guarantee, revisiting the advantages of contribution splitting and looking forward to a tax cut on the companies that they invest in.