|Sacrificing offers big gains
By Scott Francis
|PORTFOLIO POINT: The temptation to sell investment property and slam the proceeds into super is certainly attractive. Here's a variation worth considering.
Selling property to finance superannuation contributions has always been popular. Suddenly in the leadup to June 30 this year, with a special one-off $1 million contribution allowed by the Government by June 30, sales activity has surged.
But once the properties are sold, how is the money best invested? Many people assume the smartest thing to do is to get the funds from the property market and funnel them straight into tax-sheltered superannuation. For many Eureka Report subscribers, the most popular alternative would be to place the money into DIY super.
But wait a moment . there might just be a better way. It means exploiting the superannuation system, but in a way that optimises the current allowances around salary sacrifice, one of the most underestimated wealth-creation vehicles in the market, particularly since the Government made super savings more tax effective in May last year.
Under the proposed - and now almost certain to proceed - superannuation changes, having assets in superannuation make a great deal of sense. You can take a tax-free income stream from the age of 60. The superannuation fund itself, typically a DIY or self-managed super fund (SMSF), becomes tax-free once it starts to pay an income stream. You are able to take tax-free lump sums whenever you need to (unless you are taking a more restrictive complying income stream).
It's hardly surprising that the most common way to do this is by making "undeducted" or "personal" contribution to superannuation. This is being pursued by many with breathless haste since the window for the million-dollar contribution will close in less than four months.
Here's how a better way might work for you. In essence, the strategy involves keeping some money from the sale of assets outside superannuation and using it to fund living costs; allowing a more aggressive salary sacrifice strategy and therefore significant tax savings; and possible access to the government co-contribution.
Case study: Meet the Smiths
John and Jenny Smith are both earning $55,000 and are five years from retirement.
Now if we assume that they have just sold an investment property worth $500,000 and have decided to contribute this to superannuation to benefit from:
A maximum tax rate of 15% on the investment earnings of the superannuation fund.
A tax-free and flexible income stream from superannuation after retirement.
The superannuation fund being a tax-free environment once it starts to pay an income stream
The temptation is to contribute the $500,000 into superannuation as a personal contribution, and let the plan work. Indeed, this is not such a bad strategy.
There is a better way, a way that could help them increase their superannuation contribution by a further $50,000 over the next five years, and pick up a further $15,000 in government co-contributions.
Remember, the Smiths are each earning $55,000, or a total of $84,650 after tax. I'll assume this figure is their cost of living.
What would happen if, rather than contributing the $500,000 to superannuation, $315,000 was contributed and the remaining $185,000 was used to partly fund their cost of living?
They could salary sacrifice $30,000 each, taking their salary down to $25,000 before tax - the top of the 15% tax bracket. After tax they would each earn $21,775, or $43,550 combined. They could then draw $41,100 a year from their $185,000 to meet their cost of living of $84,650. Assuming a cash earnings rate of about 6%, this $185,000 will be able to subsidise their cost of living for five years.
This allows both of them to salary sacrifice all of their income that they earn above $25,000, or $30,000 each. After paying the 15% contributions tax, they will be making salary sacrifice contributions to superannuation of $25,500 each, or $51,000 in total. Over five years they will make salary sacrifice contributions of $255,000.
By keeping $185,000 out of superannuation and using it to pay living expenses, the couple have salary sacrificed (after contributions tax) $255,000 - a gain of $70,000. Of this, $20,500 is investment earnings on the $185,000 - with the remaining $49,500 being the result of tax saved.
Before the Smiths study made the salary sacrifice contributions to superannuation, they were paying a combined total of $25,350 in income tax. Using the salary sacrifice contribution, they were paying $6450 in income tax and $9000 in superannuation contributions tax, a tax saving of $9900 a year, a $49,500 saving over five years.
You will notice that where the salary sacrifice is used, the Smiths pay tax at a maximum rate of 16.5%. Their taxable income of $25,000 (each) is taxed at the maximum rate of 16.5% (that is, 15% plus the 1.5% Medicare levy) and the superannuation contributions are taxed at the rate of 15%.
Note: I have assumed that this strategy will not affect the Smiths' 9% employer contributions. Although this is true in most cases, it is worth checking this before going ahead. Employers have some room to move around the 9% figure over a certain salary band.
Keeping your portfolio balanced
Some people will rightly point out that having $185,000 sitting in cash to use to fund your living expenses will not earn very satisfactory investment returns. That is certainly a good point. My suggestion would be to consider the $185,000 and all the other assets, such as superannuation assets, as one collective portfolio and choose a suitable overall asset allocation. That might mean exposing more of the superannuation assets to growth investment classes to compensate for the cash sitting outside of superannuation.
Keep in mind that the investment returns on cash at the moment are reasonable. In the current environment a good online cash account yielding 6% will, even after tax at 31.5%, still comfortably outpace inflation.
As the cash balance decreases, and the superannuation fund increases, then the asset allocation can be adjusted.
One last bonus: the government co-contribution
The salary sacrifice that the Smiths are making will reduce their income for government co-contribution purposes, to just over $25,000 each (that is, the $25,000 they earn plus interest from their cash holding). This will allow them to make the maximum government co-contribution. They will each be able to make a $1000 personal contribution to superannuation, and the Government will put in another $1500 each year. That is a total bonus of $3000 a year or $15,000 over the five years. (In the first year or two this might be scaled back slightly, because the cash interest will just put them over the $28,000 threshold).
The benefit of this strategy
In this case a couple earning an average salary were able to save $49,500 in tax and receive a further $15,000 in government co-contributions over five years. A $64,500 benefit for being thoughtful about how superannuation contributions are made is worth considering.