Many Australians have a large amount of their wealth concentrated under the single regulatory structure of superannuation. While super remains a tax-effective investment vehicle in most circumstances, the financial planning sector and its clients have been upended by the Federal Government’s 2016 Budget proposals.
The announcement of a proposed $500,000 cap on non-concessional contributions (NCCs) over the course of a lifetime represents a dramatic change to the status quo, taking investors and financial planners off guard.
Currently an individual can make NCCs of $180,000 a year, or in some cases $540,000 every three years under the bring-forward rule. But under the proposed changes, NCCs that push above the $500,000 cap will either have to be withdrawn from the super system or face tax penalties for leaving it there.
The Government has also proposed plans to scrap the over-50s concessional (before-tax) contributions cap of $35,000, and reduce the general concessional contributions to $25,000 from its current $30,000, taking effect from 1 July 2017. This includes everything from an employer’s Superannuation Guarantee contribution, to salary-sacrificed contributions, and contributions from the self-employed.
Plus the threshold at which an additional tax of 15% (taking the total rate to 30%) is payable on contributions will apply for anyone with a taxable income above $250,000, reduced from the previous $300,000. This effectively means that the maximum tax advantage for a taxpayer earning more than $250,000 annually from contributing $25,000 to super will soon be less than $5,000.
Additionally, super rules regarding accessing funds before retirement remain rigid, and the proposed changes actively discourage retirees from using their super as a means of estate planning.
By proposing changes to superannuation’s tax advantages, the Government has left many looking for alternative ways to complement their retirement savings outside of superannuation. Some options are looking increasingly attractive, especially for individuals on higher marginal tax rates, in addition to their super plans.
The three main alternative retirement investment strategies consist of setting up a private company, buying investment (insurance) bonds, and setting up a family trust, all of which have unique taxation advantages.
Private company structures
High net worth individuals may benefit from setting up a private company, but this may only work as a tax-deferral mechanism. Earnings on funds are currently taxed at the company rate of 30% while the funds are held within the company.
However, when company profits are distributed, they are normally treated as a dividend payment and included in assessable income, attracting tax at the marginal tax rate, less any franking credits. Any tax offset for franking credits merely compensates for company profits that have already been taxed.
Company profits can be transferred to an individual as salary/wages, director’s fees, or interest on any loans advanced to the company, but those amounts still need to be included in assessable income. Similarly, if company funds are distributed to shareholders through loans or forgiven debts, they also attract tax.
A company shareholder can achieve a lower tax burden by selling an interest for a capital gain after holding it for at least one year and if 50% of the ‘discounted capital gain’ becomes exempt from tax. Conversely, if the share interest is sold for a capital loss, it can only be offset against any current or future capital gains, and is not deductible against ordinary assessable income. If an investor never offset the capital loss, the tax benefit is lost.
Investment bonds
Investment bonds (sometimes called insurance bonds) have taxation advantages that don’t exist in company structures, and a wide range of asset classes is available through a single market-linked investment vehicle.
More importantly, there were no changes mooted to investment bonds in the 2016 Budget, and there have been few significant changes to these structures in the past 20 years. Their regulatory regime has remained stable whilst super and personal income tax regimes undergo political and regulatory upheaval.
Earnings are taxed within the bond structure itself at a maximum tax rate of 30%. As an investor, investment bond earnings are not included as part of taxable income and therefore do not attract, or increase, the marginal tax rate. This means tax on investment earnings is permanently capped at 30%, offering a tax-effective savings solution for middle- to high-income earners on marginal tax rates (including the Medicare Levy) of 34.5% (for taxable incomes over $37,000), 39% (taxable incomes over $80,000) and 49% (taxable incomes over $180,000 – where there is also a 2% Temporary Budget Repair Levy).
If the investment bond is held for at least 10 years, none of the withdrawn earnings will be included as personal assessable income. With a few exceptions, such as special circumstances such as death, disability, or serious illness, the earnings component of withdrawals within the first 10 years is included in assessable income, however a 30% tax credit that has been already paid on the bond is then applied to offset the impact of the tax.
Like regular managed funds, investments held within an investment bond are entitled to full franking credits, with such credits reflected in the effective rate of tax paid by the investment bond. Earnings are automatically reinvested, which means the bond’s reinvestment dates do not need to be tracked for personal tax purposes.
There is no limit on the amount initially invested, while subsequent investments of up to 125% of the previous year’s contribution can be made without restarting the 10-year investment period. Investors also have the option of starting a new investment bond at any time for any amount. Unlike super, investment bonds attract no excess contributions tax.
Additionally, investment bonds do not carry restrictions on withdrawals prior to preservation age. For super to be non-taxable, the investor needs to be 60 and satisfy a condition of release. Funds in investment bonds can be withdrawn at any time, though there are obvious advantages to keeping money in the fund for at least 10 years.
More importantly, once taxable income hits $250,000 or more, the tax rate on super contributions under the proposed changes will be 30%, which is the same as the tax rate on investment bonds, while the latter provide greater flexibility, especially in access to funds.
With an investment bond, ownership can be transferred at any time with the original start date retained for tax purposes. In the event of death, the tax-free lump sum is paid to nominated beneficiaries or estate.
Family trusts
A family trust is a discretionary trust set up to hold a family’s assets for investment purposes. The income beneficiaries are usually the taxpayer trustee and spouse, their company, adult children, children's spouses, grandchildren and their spouses and any registered charity.
The main advantage of family trusts is their ability to arbitrage tax between family members where their income is variable and they pay different tax rates. Any income or capital gains from the trust are distributed to beneficiaries, usually annually, to those on incomes with the lowest marginal tax rates. This is particularly advantageous when some family members (but not children under 18) may be studying full-time or only working part-time.
Additionally, trustees can put money into their trust, which is then lent to the high income-earning individual for investment purposes. Instead of paying interest to the bank, they pay it to the trust and the income is distributed to beneficiaries on low or nil tax rates, making it a tax-effective form of wealth creation.
Under current family trust tax law, a child under 18 can only earn up to $416 a year tax free, after which tax rates differ depending on what offsets are available. Once a child turns 18, the tax-free threshold rises to $18,200.
Alan Hartstein is Deputy Editor at Cuffelinks. Centuria Life, an issuer of investment bonds, is a sponsor of Cuffelinks. This article is general information considered accurate at the time of writing and does not consider the circumstances of any individual.