There is ongoing controversy about the government’s proposal to increase the tax on investment earnings for superannuation balances above $3 million. The major sticking points are that the definition of investment income for this tax includes unrealised gains and that the $3 million cap is not indexed.
Before suggesting an alternative approach, let’s recognise that on the global scene Australia’s taxation of private pensions (or superannuation) is unique. In most of the developed world, contributions to pension funds and the resulting investment income are exempt from tax.
The only taxation paid is on the benefits (lump sums or pensions) paid to retirees. As with our progressive income tax, this approach is normally progressive which means that those who receive larger benefits pay a higher rate of tax on their benefits.
This was the approach in Australia until the Hawke Government introduced a 15% tax on concessional contributions and investment income with a corresponding reduction in the tax on benefits, commencing from 1 July 1988. Subsequently, the Howard Government removed the tax on benefits from 1 July 2007, thereby making most superannuation benefits tax free.
Of course, a flat tax rate of 15% on contributions and investment income is very different from our normal progressive income tax rates. To introduce some progressivity, an additional 15% tax on concessional contributions was introduced for those with incomes above $250,000. In addition, there is a tax offset for low income earners.
However, in respect of investment income, the flat rate of 15% remains except for those in a pension product, where the tax rate is zero.
One purpose of the proposed tax on investment income is to introduce some progressivity into the tax paid on investment income, which would only affect those with higher superannuation balances.
Is there a simpler way to introduce greater fairness?
Australia has developed a very good superannuation system that accumulates funds for retirement. But we do not have a retirement income system as there is no requirement for Australian retirees to withdraw their superannuation during retirement. The money can stay in the system until their death.
This is contrary to most other well-developed pension systems where money must be gradually withdrawn from a certain age. For example, in the USA, there are required minimum distributions from age 73. Such an approach means that the accumulated funds are used to provide retirement income and not for direct intergenerational wealth transfers. This approach also limits the growth of superannuation balances during retirement.
The legislated objective of superannuation in Australia is to preserve savings to deliver income for a dignified retirement, alongside government support, in an equitable and sustainable way. Note that the primary purpose is the provision of retirement income, not estate planning.
Currently, there are minimum drawdown rates that apply to pension products which range from 4% of the account balance for those age 60-64 to 14% for those aged 95 or more. But there is no requirement for a retiree to transfer their accumulated superannuation into a pension product. Hence, many older wealthy Australians deliberately leave their superannuation in the accumulation phase and do not receive any retirement income.
Let’s consider a high net worth individual aged 75 with $6 million in their superannuation account. As they do not need any income, the funds remain in super with the investment income taxed at the concessional tax rate of 15%.
Under the proposed new tax, this individual would be subject to an additional tax of about $30,000, assuming an after tax return on their super of 7% in the previous 12 months, including income and capital gains (both realised and unrealised).
However, the new tax will not require any drawdowns during retirement. The superannuation balance can continue to grow, even during the retirement years.
However, if we were to apply the minimum drawdown rates that apply to pension products for this 75 year old, the individual would be required to withdraw $360,000 from their super during the next year. In other words, the superannuation balance would gradually reduce during retirement.
Of course, this alternative approach would not generate any additional tax directly from superannuation. However, it is likely that most of the withdrawn amounts for wealthy retirees would be invested elsewhere and therefore the resulting investment income should be subject to other forms of taxation.
As noted earlier, the proposed tax has been criticised for the use of unrealised capital gains and the lack of indexation. In effect, it is a complex measure to introduce improved fairness into the superannuation system.
A more significant reform would be to require all Australians above a certain age (say age 75), to gradually drawdown their superannuation or to invest in an approved pension product. Some individuals who have a significant single asset in their superannuation fund (such as a single property or farm) are unlikely to not support this direction, but this reform would be consistent with the legislated objective of superannuation. It would also be consistent with the policies of the best pension systems in the world which provide regular retirement income and are not primarily used for estate planning.
Dr David Knox is an actuary and has recently retired from being a Senior Partner at Mercer.