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How the $3 million super tax impacts unfunded pension schemes

A Senate Committee reported back last week with a majority recommendation to pass the $3 million super tax unaltered. It would appear that the Committee was swayed in its conclusions by the evidence from Treasury which “observed that the draft regulations for defined benefit interests reflect the need to ensure that the changes apply equally to all different types of superannuation interests.”

Furthermore, the Committee’s report states that “Mr Hawkins [Treasury's Adrian Hawkins] reiterated that the calculation of an interest under the changes has been designed to ensure that the approach is consistent across defined benefit members and accumulation members.”

The objective of these proposed Bills, and the associated regulations, is to ensure the better targeting of superannuation tax concessions which apply to superannuation assets accumulated under the Superannuation Guarantee arrangements. The proposed changes will increase the maximum headline marginal tax rate on superannuation fund earnings from 15% to 30% for earnings corresponding to the proportion of an individual’s Total Superannuation Balance (TSB) that is greater than $3 million. The reforms introduce a new Division 296 into the Income Tax Assessment Act 1997. Earnings from superannuation assets below the $3 million threshold will continue to be taxed at just 15% or exempt from income tax if held in a retirement pension account.

Unfunded super schemes are being unfairly treated

While funded superannuation has benefited from these open-ended tax concessions, superannuation payments from unfunded sources, such as those applying to many Commonwealth and State employees, are taxed as normal income and do not receive these tax concessions. Governments did not put aside funds to meet these superannuation obligations to their employees and made conscious decisions to fund the obligations as they fell due following an employee’s retirement.

Much of the discussion around the Better Targeting of Superannuation Tax Concessions, including the comments from Treasury to the Committee, conveniently ignore this important difference in how superannuation is taxed.

The draft legislation for this reform did not fully outline how unfunded superannuation would be treated and left the special rules for the modified treatment of unfunded superannuation and some retirement phase interests, including the valuation of such interests, to be addressed through specific provisions in subsequent regulations.

The draft regulations were finally made public on 15 March 2024. They detail how unfunded superannuation will be valued and Division 296 tax subsequently determined. They take no account of the current taxation arrangements currently applying to unfunded superannuation.

As a result, the inclusion of unfunded superannuation in Division 296 tax proposals is neither equitable, or just.

Under the proposed regulations an individual in receipt of an unfunded superannuation payment of $300,000 per annum will be subject to a Division 296 tax assessment of around $7,000. A number of factors affect this assessment including the individual’s age, their sex and the CPI. In this example the individual is assumed to be a 67-year-old male, and the CPI was assumed to be 3%. Application of the regulations using these assumptions would ascribe this individual a total superannuation balance of around $3,555,000, with earnings for the year of around $297,000 or 8.36%.

The Division 296 tax assessment is in addition to the normal income tax of around $105,000 which the individual would pay.

In contrast, an individual who has the equivalent superannuation assets, around $3,555,000, earning a similar amount, around $297,000, and drawing the same total income of $300,000, would be subject to a total tax bill of just $27,700.

While the application of the Division 296 tax may be consistent across these two individuals, in that they both would pay the same $7,000 Division 296 tax, it is clear that the latter benefits significantly from the superannuation tax concessions which are not available to those in receipt of unfunded superannuation.

Were the individual in receipt of the unfunded superannuation payment of $300,000 a woman the Division 296 tax assessment would increase significantly to around $12,000. This is hardly treating defined benefit members and accumulation members in a consistent manner as stated by Treasury.

Other areas of inconsistency

There are many other areas where the proposed legislation does not treat individuals in a consistent manner as asserted by Treasury. These include the following:

  • Those holding in excess of $3 million in a superannuation fund will be able to readily escape the full impost of Division 296 tax by moving some of their superannuation assets to other tax effective places. Individuals receiving unfunded superannuation are unable to access any of the unfunded asset that will be ascribed to them in the Division 296 regulations and cannot take any actions to limit the impact of a Division 296 tax impost;
  • In retirement mode, the earnings of the first $1.9 million of an individual’s superannuation asset will remain tax exempt. In contrast the full amount of an unfunded superannuation pension will continue to contribute to an individual’s personal income tax assessment with normal marginal income tax rates applied impacting them as shown in the example above;
  • Earnings from an individual’s superannuation asset valued between $1.9 million and $3.0 million will continue to be taxed at only 15%. On the other hand, unfunded superannuation which is ascribed under the proposed regulations to be derived from a fund valued towards the top of this range, is likely to be exposed to the top personal marginal income tax rate of 45 percent; and
  • Earnings from an individual’s superannuation asset in excess of $3.0 million will attract the Division 296 tax loading of 15% taking the marginal tax rate to 30%. Unfunded superannuation pensions, assessed under the Regulations to incur the Division 296 loading of 15%, will have that loading applied on top of the existing 45% marginal personal tax rate that will almost certainly apply to that pension.

It is unfortunate that some commentators are muddying the waters in respect of the taxation arrangements applying to unfunded superannuation. These commentators confuse the taxation arrangements applying to funded and unfunded superannuation and frequently make reference to retirees receiving up to $118,750 tax free.

Such comments are irrelevant in the case of an individual in receipt of an unfunded superannuation pension that may be subject to Division 296 tax. These individuals are not in receipt of this tax benefit, and as stated above, and shown in the example, are almost certainly already paying a marginal tax rate of 45% on any income ascribed to them under a Division 296 assessment applied to that unfunded superannuation.

The stated purpose of the Government’s Division 296 measures is to ensure the better targeting of superannuation tax concessions.

As ACPSRO and others have demonstrated, unfunded superannuation does not attract these concessions and should not be included within the Division 296 tax arrangements. The application of Division 296 tax to an individual’s unfunded superannuation will amount to the double taxation of that superannuation and impose an effective marginal tax rate which is likely double that proposed under the government’s reforms.

 

John Pauley is President of the Australian Council of Public Sector Retiree Organisations.

 

27 Comments
Jane A
May 27, 2024

John, perhaps you can help me with my concern. As a widow still supporting a child I am in receipt of my husband's reversionary CSS pension and my own much smaller PSS pension. Taken together they put me in the highest tax bracket. It is not clear to me if the two pension streams will be considered as one for the new tax. Can you advise if the proposed regulations cover my situation? Many thanks.

John Pauley
May 28, 2024

Hi Jane,

The only advice I can offer is that you see a financial advisor if this legislation and regulations are passed by the Parliament.

However, I can say that in assessing your super under the proposed Division 296 tax all the super balances you have, and are ascribed to have, are added together to see if the $3 million dollar point is exceeded. Each unfunded pension will be ascribed a value and added to any other monies you may have in super.

I can also say that you will be more harshly treated by this proposed legislation than a person in receipt of the same after tax income from a fund accumulated under the superannuation guarantee arrangements.

Also, as a woman you will likely be ascribed a higher valuation under the proposed regulations than a man of the same age and in receipt of the same unfunded superannuation income.

The exact impact will however be dependent upon you precise circumstances and only a competent financial advisor with experience in the defined benefit superannuation space can advise you completely.

Jane A
May 28, 2024

Thank you for your response John.

Cam
May 26, 2024

My impression is the Government doesn’t care whether the tax is fair. I’m concerned they have the same attitude as they did with the franking credits policy for the 2019 election.
This new tax affects a lot less people, and it’s less damaging bringing in a tax like this midway through a 3 year term in Government rather than as the Opposition in an election campaign.
Governments of both persuasions have pandered to their base, marginal electorates, etc. Not caring about the voting base of the other major party takes things to a concerning next level.

John Richard Pauley
May 26, 2024

Hi Steve, just for the record, this is all about Division 296 tax.

The objective of Division 296 tax is to better target superannuation tax concessions and unfunded superannuation is not in receipt of these tax concessions, and are fully taxed. Yet this proposed legislation seeks to treat unfunded superannuation in the same manner as funded schemes, yet as you say they are subject to totally different tax arrangements.

As for the hypothetical $100,000 income stream. Whether funded or unfunded, neither are subject to Division 296 tax. And the $100,000 from a funded scheme is, in fact, tax exempt. We could go on forever discussing the pros and cons of unfunded vs funded superannuation arrangements and there are arguments in favour of both.

Bruce
May 25, 2024

Unfortunately these changes will discourage young people who have 40 years till retirement to consider making any after tax contributions to their fund.
Gen Z have no certainty that any future changes will be ‘grandfathered’, while facing the risk of major changes to the rules. For example, restricting withdrawals to 10% of a fund’s balance; raising the age when a person can access their super to 65, increasing the tax on payments to beneficiaries from 17% to 30%, or increasing the tax paid on earnings in accumulation mode to include the Medicare levy.
While most young people I talk to have no interest in superannuation. Those who are financially savvy would rather spend any spare cash on their lifestyle rather than salary sacrifice to increase their super balance 40 years from now.

As for whether DB super is better than current super schemes, DB super schemes did not allow the employee to transfer to higher paid employment outside the public service without a serious loss of retirement income.
If the Government wants to include DB pensions in Div296 assessments it should also commit to allowing holders of these pensions to transfer their notional balance to another super fund. I expect the reason that this will never happen is because Treasury knows that most DB pensioners would prefer to have their money in an Industry or SMSF.

James
May 25, 2024

All this demonstrates is that Chalmers' "brilliant" idea is an egregiously bad one that should be consigned to the waste bin! Collateral damage and unintended consequences result because of labor's visceral hate of SMSFs, that are no doubt, the main target here!

Perhaps consider your vote carefully at the next election because who knows what other delightful surprises are in store. Labor's 2019 election agenda is a pretty good guide I'd suggest. I'm sure it's patiently resting in Chalmers bottom drawer. And remember this is the economic numpty (a Doctor of economics he is not) that believes he can reshape capitalism! Such hubris!

Jon Kalkman
May 24, 2024

Before we consider the tax rates of a DB pension compared to an account-based pension, we must acknowledge that there is no equivalence between them. A Commonwealth DB is absolutely risk-free, just like the age pension. But an independent (self-funded) retiree needs to manage a host of retirement risks that the DB pensioner does not. They include longevity risk, market risk, inflation risk and sequencing risk. And as recent events demonstrate, they can add legislative risk as well. All risk management requires an assessment of the probability of a negative event and the severity of its impact. That assessment may vary greatly between individuals, but account-based pensions are definitely NOT risk-free.

Of course, independent retirees can, for a fee, transfer those risks to a third party with an annuity. Challenger will sell an annuity to a 65 year old male that pays about $5000 per year paid for life, indexed to inflation with no residual on death. That annuity would cost $100,000. Women pay more because they live longer. Therefore, if the Commonwealth Government were to buy an annuity on behalf of our retired male public servant that paid $300,000 per year, it would cost the taxpayer $6 million. That is the starting point for a tax discussion.

But the DB pensioner must pay tax on that income, whereas the independent retiree receives the account-based pension tax-free. I would argue the after-tax differential covers the cost of self-insurance the independent retiree needs in order to manage the range of risks in retirement.

OldbutSane
May 24, 2024

Would like to know how the value of a CSS pension is defined. How is it calculated? If pension has existed for years and had $800k value when $1.6m limit was introduced does it retain that value or does it change every year depending on income? Current income about $60k but also have SMSF worth about $2m, so close to $3m limit

John
May 26, 2024

My commencing CSS annual pension was multiplied by 16 to deem the value of funds supporting that pension. i.e. a deeming rate of 6.66%. e.g. A $100k initial pension would result in a $1.6m reduction in Transfer Balance Cap.

OldbutSane
May 24, 2024

Would like to know how the tax applies to someone who has a more modest unfunded CSS pension with SMSF pension (at $1.6m limit) plus an amount in an accumulation account with current total (pension and accumulation) about $2m. CSS pension was valued at about $800,000 when $1.6m limit was imposed. How is value of CSS pension calculated in these circumstances eg does it stay at $800k?

Sean
May 27, 2024

Defined benefit interests that are in pension phase are largely valued one of two ways:
- The family law court valuation of the defined benefit interest (which is similar to the above, but with allowances made for various different modifiers life expectancy, reversion etc)
- An actuary can determine the value (so long as it's within 10%+/- of the family law court value)

And, that will change every year as you will adjust for things like CPI, life expectancy etc.

Stephen
May 23, 2024

A few inconvenient facts.
Firstly, a lifetime indexed pension of $300,000 is in anyone’s world very , very generous.
Secondly, such individuals were the main beneficiaries of the Stage 3 tax cuts.
Thirdly, an unfunded pension receives a tax rebate of 10% of the first $106,500 - $10,650 per annum, so even though the pension is nominally subject to full tax rates, the full rate of tax is not paid on the pension.

The writer overstates his argument and diminishes it by omitting these facts.

Steve
May 24, 2024

'The writer overstates his argument and diminishes it by omitting these facts.'

100% agreed and it is a tenuous argument that really should not have been presented. If that is the best that can be provided then it serves to prove that the scheme is fair as proposed.

At the end of the day John is just talking his book like anyone would do in his position - just a shame that he is clutching at straws and any reasonable analysis would tear it to shreads,

'John Pauley is President of the Australian Council of Public Sector Retiree Organisations.'

John Pauley
May 25, 2024

Thanks so much for pointing out this mistake in my calculations. I have also left out the Medicare levy as well which would be $6,000 on an income of $300,000. This balances out a significant portion of the Tax Offset, but the argument remains the same, unfunded superannuation is subject to normal income tax rates and does not benefit from the generous tax concessions available to superannuation guarantee schemes.

As others here have pointed out the interaction of the superannuation and the tax system are complex, and this legislation does nothing to offset this.

Cam
May 26, 2024

Agree re $300k a year in retirement being a lot higher than most. Noting stage 3 tax cuts favouring higher incomes but ignoring stages 1 and 2 favoured lower incomes overstates the counter argument.
I think your point about $300k annual income in retirement though is what most people will think.

Algynon
May 23, 2024

DB funds are nothing if not complicated. I haven't read the regulations. My simplistic calculations don't arrive at the $7,000 shown for the tax on the "over $3 million" component for the $300k DB pension.
The valuation of the pension is $3,555,000, so the amount subject to 30% tax is $555,000. The earnings are 8.36%, or $46,398. 30% tax on those earnings would be $13,919, approximately double the $7,000 estimate in the article for the Division 296 assessment.
I am obviously missing something. What is it?

Davidy
May 23, 2024

For perspective, how many retirees are likely to be effected by the new rules (Treasury has estimated around 80,000 people in total numbers under this new law) ?

G Hollands
May 24, 2024

The latest figures are at about 100,000!

Steve
May 23, 2024

John, it appears that this is the main issue you raise.

'While the application of the Division 296 tax may be consistent across these two individuals, in that they both would pay the same $7,000 Division 296 tax, it is clear that the latter benefits significantly from the superannuation tax concessions which are not available to those in receipt of unfunded superannuation.'

That of the difference between funded and unfunded Super and the general taxation of each whilst accepting that the Div 296 will impact each equally, if male.

So really your argument should be about the merits of funded vs unfunded pensions.

A significant amount of my pension fund has been after tax contributions over many years. For these funds I do not see any unfairness at all, I paid marginal rates on the money going in, and tax free when coming out. Unfunded plans receive very generous pay-outs which in effect are just a continuation of a % of salary but no need to show up for work :-) No market risk, just take the $ until you die. Nice if you can get that,

Also to note that you use a figure of a $300,000 pension to make the point of a tax liability of $7,000. I assume you arrived at that figure as it allowed a point to be made, although rather mute as you concede it is no different to a taxed super pension. Most pension recipients, even Firstlinks readers, would love to have a $300,000 a year pension taxed or non taxed! Hoe do the numbers look if you use a $100,000 per year pension which may be nearer what most folks would receive?
Cheer

John Abernethy
May 23, 2024

Thanks John,

You have clarified some of the issues, but in my opinion, you have not properly covered all the issues concerning a tax on "unrealised capital gains".

Your explanation of the tax rates for unfunded and funded defined benefits is very useful. Thank-you for the clarification.

I want to examine your example of an unfunded superannuation pension payment of $300k in a year - notional pretax benefit - and the $105000 full tax paid on it to net $195000.

A SMSF holder would look at it differently and say the recipient is actually receiving a $195k tax free or tax paid pension which is continuously indexed for life and part transferable to a partner on death. The tax paid is actually a "round robin" (government pays and government collects on behalf of the Australian tax payer) but I understand why the defined benefit recipient would see it differently.

From a funded SMSF perspective, saving and contributing $3.5 million into a pension fund (yes it was invested and accumulated to grow the capital - but it was taxed on earnings and contributions) is a life time endeavour. A SMSF contributed funds their whole working life.

The SMSF beneficiary drawdowns the their pension fund as the they age in retirement. The capital drawdown accelerates as the beneficiary passes through age bands. The capital is greatly depleted meaning the investment income in the fund is also depleted and probably won't cover the pension paid out in later years.

However, the unfunded defined pension beneficiary keeps on compounding his pension payout by inflation. It does not decrease. In 10 years (assume 3% CPI) a $195k pension per annum on receipt grows to $262k per annum. In 20 years the pension on receipt grows to $352k per annum. There is no investment risk to this pension and it is inflation protected.

Finally, back to unrealised capital gains. In your commentary you take the position that unrealised capital gains are income. That has not been the accepted position in tax law. Indeed, that is the real issue and not necessarily taxing super or pension tax funds on income, at higher rates at some point.

I do not wish to be critical of your article but merely want to point out as to why contributing SMSFs do not look favourably towards those who will benefit from large pensions received in unfunded defined benefit schemes.

Public servants and defence personal will rightly state that they signed up for these benefits. However, the Government advised by Treasury, did not properly understand what they committed the tax payer to. Further, when Parliamentarians and Treasury advisors from a bygone , unfairly benefit from their poor public decision making, then today's tax payer is rightly annoyed at the payments been drawn from our taxes.

However, let's be clear. The Future Fund that now has $230 billion in it, was designed to pay out the unfunded pension liabilities and to do so by 2020 (original design). It has still not paid a pension and the Treasury forecasts, inherent in the FY24 budget papers, assume that the Future Fund will still not pay a pension any time soon. Why?

A final point - it appears that the budget expensed, and the taxpayer therefore paid, about $13 billion in defined benefit pensions in FY24. It is forecast grow to over $17 billion by FY27. These payments represent 2% of budget outlays yet it is never discussed publicly.

peter care
May 24, 2024

John Abernerthy ( Clime ?),

One further difference between the account based pension recipient and the defined benefits recipient is what happens should they die. It is particularly harsh or single defined benefits recipients. For example a 60 year old single person who converts $1 million to an account based pension and withdraws the minimum and dies at 75 should expect to pass $1.3 to $1.6 million to their estate (including adult children). A defined benefits recipient who converts $1 million to a defined benefits pension , will receive a higher pension but their estate will receive nothing when they die at 75.

In fact one large defined fund passes nothing to their estate if the superannuant dies at 69.

So it’s swings and roundabouts.

It pays to live a long life.

Steve
May 25, 2024

Peter, point taken. But could you reconsider your assumptions. You suggest a minimum drawdown, but what if one were to drawdown sufficient $ to be equal to the after tax pension of the Government Defined Benefit Plan, and thus increasing every year with inflation? I think the poor soul would run out of funds by age 75, and thus nothing to be left to their estate from the Super Fund.

The fund will become zero when you reach the age of 73, assuming a starting fund of $1,000,000 with a 7% annual growth rate, and an initial drawdown of $100,000 that increases by 3.5% each year.

SO your argument is rather mute. At age70 we have one living in fear of their money running out in 2/3 years time, and the other happy knowing that their gold plated pension will continue as long as they live and probably their spouse will continue to receive a part pension.

John Pauley
May 25, 2024

Thanks John for clearly demonstrating how the proposed Division 296 tax legislation adversely affects those on unfunded superannuation pensions.

In the example you have used of an individual in receipt of the same after tax income there would be no Division 296 tax assessed on their fund accumulated under the superannuation guarantee arrangements. Their total tax liability on net earnings of around $190,000 would be just over $5,000, less than the Division 296 tax assessed on an individual in receipt of an unfunded superannuation pension.

This clearly highlights the point we make, which is that those on unfunded superannuation are not in receipt of the tax concessions available to those whose super is provided under the superannuation guarantee arrangements, and that the proposed legislation does not treat alternative superannuation arrangements consistently as purported by Treasury.

Steve
May 26, 2024

John, with the best will in the world, you are attempting to mix up two very separate arguments to justify the headline.

'This clearly highlights the point we make, which is that those on unfunded superannuation are not in receipt of the tax concessions available to those whose super is provided under the superannuation guarantee arrangements, and that the proposed legislation does not treat alternative superannuation arrangements consistently as purported by Treasury.'

Yes, there is an argument about taxed and untaxed funds and how they are treated. Generally those with gold plated taxpayer at risk funds think they are hard done by. And often as a result of reading items like yours and allowing their own biases to colour the logic. In any event this has nothing to do with Div 296.

There is a separate issue concerning Div 296, but as you have pointed out yourself if is about level based on a $300,000 pension. So there is really no argument there. What you have tried to do is to tie the two items together and stir the pot using the Div 296, as a megaphone for your general argument about taxed vs untaxed funds.

You have yet to run the numbers based on the $100,000 pension which is far more realistic for most folks. Would you do this just for the record? Cheers

lyn
May 26, 2024

John Abernethy, all well put. I too have wondered why Future Fund intended on establishment for future liability of Govt pensions not been utilised yet when seems to have performed reasonably. Usually look at its' Balance Sheet when these discussions appear, interesting reading, you saved me time this time. If $13billion DBPs in 2024 why are they not dipping into it to assist overall Budgeted expenditure? Must surely be the time for a monthly 'contra' contribution from FF to the bank account/code paying the pensions? More of us should be asking why not. $13bill p.a. would help more subs/warships to start building a.s.a.p, very few existing ships to protect enormous island nation when our Allies need so much sea-time to reach us. Happy I don't live on our coastline.

Linda
May 26, 2024

I agree Lyn.

I cannot understand why the Future Fund continues as an accumulation fund when the tax payers are contributing $13 billion pa to defined benefit pensions.

On my understanding of the budget, the $13 billion would bring the cash deficit back towards a balanced level - assuming Treasury is forecasting correctly.

It is high time the parliament produced a report for the tax payer that outlined the band levels of unfunded defined benefit payments. Who is receiving the highest unfunded DB pension today? Former Prime Ministers? Former Cabinet Ministers? Former Army Generals? Former High Court judges? It would make interesting reading and especially if the example of $300k pre tax is greatly exceeded by certain recipients.

 

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