I promise this will be my last article for a while on Division 296 tax (the proposed new tax for people with more than $3 million in super). There are other interesting things to talk about when it comes to super. But with so much commentary about the need to ‘do something’ to respond to the new tax, I wanted to throw my thoughts into the mix.
A controversial view: lots of people with less than $10 million in super should do absolutely nothing. And even some with more than $10 million should think carefully before doing anything drastic.
Let me explain.
Say Peter is 65 (so can withdraw money from super if he wants to), is in good health and has $7 million in super in his SMSF, including a $2 million pension. Division 296 will effectively turn Peter’s super into a vehicle where every $100 of earnings is divided into three parts:
- Around $29 (earnings relating to the 29% of his fund in a pension) will be tax free
- Around $14 (earnings relating to the rest of his super up to $3 million) will be taxed at 15% (the normal super tax rate), and
- Around $57 (earnings relating to the proportion of his super over $3 million) will be taxed at 30% (the normal fund tax rate plus 15% Division 296 tax).
The maths doesn’t work quite that way but… it’s close enough.
Firstly – there’s plenty of commentary that will remind us Peter’s effective tax rate is still only around 19% (ie, the total tax taken from that $100 will be $19 if you add them all up). Let’s ignore that analysis right from the start. Effective tax rates are useless when thinking about what Peter should do. Unless Peter is seriously thinking about withdrawing all of his super (unlikely), we only care about the tax paid on earnings from that last $4 million (the bit over $3 million).
Think of it this way: when you’re weighing up the value of a tax deduction, you don’t calculate your effective tax rate. You think about your marginal rate of tax – how much tax will I save if I claim this deduction? The same principle applies here – effectively Peter now has a quasi-marginal rate of tax on his super fund’s income of 30%.
So let’s talk about that part of his super – the $4 million or 57% of his super that is over the $3 million threshold.
What would happen if Peter moved that money out of super? He’d invest it elsewhere. That ‘somewhere’ will involve tax. Let’s look at the tax on regular income first – say it generates $200,000 (5%) in income each year.
If he invested it in his own name, most of it will be taxed at more than 30% (the 30% marginal rate cuts in at $45,000 and even then, the addition of the Medicare Levy means it’s actually 32%).
Someone with this much in super probably already has assets in their own name (or in another vehicle like a family trust that distributes income to them) – so it’s entirely possible he’s already using up the lower tax thresholds and all of the $200,000 would be taxed at more than 30%.
(In fact, if Peter’s not receiving at least around $30,000 in personal income each year, he probably should have moved some of his super into his own name years ago – to benefit from the fact that he can pay zero tax on his personal income if it’s that low.)
What if Peter put the $4 million he might move out of super into a family trust and distributed it to lots of beneficiaries on low tax rates?
That might work – but remember even at $45,000 income pa they’re paying more than 30% tax (thank you, Medicare Levy). He’d need a few beneficiaries. And then there’s the awkward need to actually give them the money or the ATO comes calling.
Alternatively, Peter could move this $4 million out of super, hold it in a family trust and distribute the income to a company (a beneficiary of the trust). There are a few challenges here. If Peter wants to actually use the money for something, he’d have to take it out of the company by taking a dividend. That’s a problem. It’s taxable. And if Peter’s personal tax rate is high. he’s back to paying more than 30% tax again.
Finally, Peter could consider a product like an investment bond. These are great products – the way they work is that someone like Peter could put his $4 million into one, leave it alone for 10 years and then get it back with no extra tax paid in his personal return. Sounds like a tax-free win! But behind the scenes it’s not exactly tax free. Throughout that 10 years, the investments within the bond have generated income (taxed at 30% within the bond itself), assets have been bought and sold (with capital gains taxed at 30% within the bond) and when the money is returned to Peter the ‘price’ he gets reflects the tax that would be paid if all the investments were sold. So these aren’t really ‘tax-free’ vehicles – more like ‘tax paid behind the scenes’. Still great for the right purpose but not tax free – effectively Peter is paying 30% somehow. (Note – like individuals and trusts, bond products get to reduce their tax bill using franking credits, so their effective tax rate is often less than 30%. But that’s a red herring – for the purposes of deciding what to do, Peter should ignore this. He would get exactly the same benefit from franking credits no matter where he held the money.)
So far, we’ve just looked at income. But what about capital gains?
Modelling I’ve done on this makes it clear that even capital gains are generally taxed less in super. Perhaps it should be obvious. This is over simplistic – but capital gains in super are taxed at 20% at worst (both the super fund and Division 296 taxes are only applied to two-thirds of the capital gains tax, ie the tax rate is at worst 2/3 x 30% which is 20%). In contrast, a capital gain in a company is taxed at 30% and a capital gain distributed to an individual will inevitably push up their marginal tax rate. For someone like Peter it’s hard to see how he could avoid paying the top marginal rate of tax on a lot of the gain. Since individuals only have to pay tax on 50% of their capital gains, that translates to a tax rate of 23.5%.
(In fact, the maths isn’t quite this simple – I modelled a host of different scenarios but came to the same conclusion.)
And throughout all of this, I’ve ignored one big elephant in the room: it’s unlikely Peter’s SMSF could simply pay out $4 million without selling some assets and realising capital gains tax. The cost to move could be significant for, what appears to be, little benefit.
What would encourage Peter to remove some of his super?
While Division 296 tax isn’t necessarily a decisive driver for Peter to take money out of super, there are plenty of reasons Peter might want to anyway.
Super isn’t a forever vehicle
Some or all of everyone’s super has to come out of their fund when they die. At that point, Peter’s family won’t have a choice, they’ll have to do something.
The trouble with death is that it sets a deadline – super benefits have to be paid out as soon as practicable. That will give Peter’s family a relatively short window to manage withdrawals in an optimal way. (And – a story for another time – when it comes to minimising fund tax and Division 296 tax, it’s almost always better to have the luxury of doing this over time).
It also means there’s no such thing as an intergenerational asset in super – everything is eventually sold or transferred out of the fund (with capital gains tax, stamp duty etc). In contrast, assets bought in a family trust might be kept for several generations with no disruption. Capital gains tax will be paid one day but, who knows whose problem that will be?
(There are some rare exceptions – where children belong to a parent’s super fund and have high enough balances themselves to effectively ‘take over’ the fund’s long term assets. This is becoming harder and harder as today’s Gen X / Gen Z children simply can’t build up as much super as their Boomer parents did.)
Death taxes
These are without a doubt the biggest destroyers of intergenerational wealth transfer when it comes to super. It’s highly likely a large part of Peter’s super will be subject to tax of at least 15% if it ends up with his adult financially independent children. And remember – it’s a tax on capital not income. The numbers for Peter could be huge – 15% of $7 million is over $1 million.
If Peter has a spouse, he won’t be too worried about death taxes yet since spouses can inherit each other’s super tax free. But it will be a consideration one day if his spouse pre-deceases him.
These two factors might prompt Peter to think beyond the simple analysis presented earlier. A more sensible mindset might be:
- Thanks to Division 296 tax, super is less tax effective for me than it used to be,
- It’s actually still a bit better than investing outside super but at least for my $4 million over the Division 296 threshold, it’s closer. I don’t need to hang on to absolutely every opportunity to leave money in super,
- For now, I’ll do nothing as both my spouse and I are healthy, but where I will take money out of super is if:
- My spouse dies (and I want to get in early to move wealth and avoid death taxes), or
- I want to buy an asset that I expect the family wants to hold for a very long time (eg property). Given my age, I might as well buy that in a more ‘long-term’ vehicle.
Heffron has recently revised it's Client Guide on Division 296 tax, which can be downloaded here (details required).
Meg Heffron is the Managing Director of Heffron SMSF Solutions, a sponsor of Firstlinks. This is general information only and it does not constitute any recommendation or advice. It does not consider any personal circumstances and is based on an understanding of relevant rules and legislation at the time of writing.
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