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Is a ‘transition to retirement’ pension worthwhile?

In an earlier Cuffelinks article (Edition 2: The superannuation essentials), I covered the basic concepts of superannuation and its tax advantages. One of the breakthrough government initiatives was to allow people to access super whilst still working. This has created three broad financial planning strategies:

  • work less hours, and top up your lost income by drawing down from a pre-retirement pension
  • continue working full-time, but restructure your salary and super to give the optimum split that maintains your after tax income whilst tax effectively boosting your retirement savings
  • keep working full-time, maximise your salary sacrifice and convert the bulk of your super to the pension phase to avoid paying tax on performance returns.

The attraction of the pension strategies depends on the amount you have in super and your PAYG marginal tax rate, and crucially, whether you have reached your preservation age. For people born before 1 July 1960 the preservation age is 55. People born after 1 July 1964 have to wait until age 60. There is a sliding scale preservation age for people born between those two dates - either 56, 57, 58 or 59. This is one of the many complexities caused by ‘grandfathering’ where governments try not to disadvantage existing superannuants.

Strategy number one is what the government envisioned when they allowed people to access their super whilst still working. The other two were created by the financial planning and wealth management industry which spotted an opportunity to save their clients tax.

There are a number of iterations of the transition to retirement strategy. In its purest form it comprises three steps:

  • converting most of your super to the pension phase
  • increasing the amount you salary sacrifice
  • drawing down a monthly payment from your pension.

In this way you are creating sufficient after-tax income, but because of the preferential tax rates in super and pension, you are better off from a tax perspective.

I say ‘most of your super’ because having set up a pension you can’t add your future super contributions to it. Consequently, you have to leave a small amount in your super account.

The transition to retirement initiative has opened the door for many people who are still working full-time. Some people do not need to maintain their income as they have sufficient to cover living expenses and emergencies. They are already maximising their salary sacrifice contributions, and are looking for ways to save more tax. For these people, the potential benefit of a pre-retirement pension has nothing to do with maintaining income. The attraction is that superannuation assets in a pension pay no tax on performance returns, whereas in accumulation the tax can be up to 15%.

Furthermore, although it’s paying no tax, a pension fund can still claim back its franking credits. For example, if the fund receives a dividend of $700 from an Australian company with a franking credit of $300, it will pay no tax on the $700 dividend but receive a tax refund for the $300 franking credit, giving a total cash return of $1,000.

So should everyone be converting their super to a pension once they reach their preservation age? Well, in at least two circumstances, the benefits significantly outweigh the disadvantages:

  • you are aged 60+
  • you are exclusively using non concessional contributions to start the pension.

In both these instances there’s no tax on pension payments or the performance returns in the pension. The only downside is that legislation decrees that you have to withdraw between 3% and 10% of the pension balance each year, so you are lowering your eventual retirement nest egg. But this is not a major problem as you can simply put it back into super tax free (provided you do not exceed your $450,000 non concessional limit over three years). The minimum pension payment rises to 4% next year so you need to take that into consideration.

If you are between 55 and 59 it all depends on a complex set of variables – your super balance, the split between tax free and taxable component, performance returns, the split between income and capital growth, the amount of share transactions, the pension payment amount and your marginal tax rate.

Let’s say you have $300,000 in super, totally invested in cash deposits that deliver 4.5% interest and your marginal tax rate is 38.5% including Medicare. The contributions in the fund comprise 100% employer and salary sacrificed contributions (to use the industry jargon, it is 100% taxable component). If you leave it in super, the interest earned is $13,500 which is taxed at 15% ($2,025).

If you convert the super to the pension phase, you will have to withdraw 4% in the 2014 tax year ($12,000). As the money is 100% taxable component you will pay 23.5% tax on the pension (38.5% less 15% tax rebate) which is $2,820. So in this example you are $795 worse off by converting to a pension, and you’ve taken $12,000 out of a concessionally taxed environment.

Once you start increasing the return, the position starts to favour the pension option, but there may be a joker in the pack if your super fund invests in a managed fund with active share trading. It is common for a fund manager to sell half the companies in the portfolio over the course of a financial year. This often creates realised capital gains that are taxed at 10% in the accumulation phase, but not in the pension phase. This activity could well swing the decision, but it’s very difficult to assess.

The variable that really changes the ball game is the split between taxable component and tax free component. The tax free component comprises the after tax contributions you have made to super. Let's say the split between taxable and tax free component is 50/50. Keeping the other assumptions constant, there’s still not much saving with $300,000 invested in cash deposits with a 4.5% return. But if you either increase the balance or the return, the picture changes significantly. With a balance of $300,000 and a return of 7%, you are $1,740 a year better off converting your super to a pension. With a balance of $1 million and a return of 4.5%, you are $1,950 better off.

Can’t be bothered with the hassle? Well, a 55-year-old couple with $1 million each in super which delivers an average return of 8% per annum could pay an unnecessary $73,000 more in tax over the five year period by waiting till they reach 60 to convert their super to a pension.

So my advice is to get out the calculator, or better still, consult a financial adviser who has access to modelling software. You may get an early Christmas present from the Tax Office.

 

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