It’s apparent from comments posted on Cuffelinks that many people regard tax-free superannuation after the age of 60 as overly generous. They claim that tax-free super introduced in 2007 by Treasurer Peter Costello forfeited tax revenue making the system unsustainable in the long term.
Types of contributions
Let’s start with the basics. There are two types of contributions to super. Concessional contributions are made before tax is paid, such as salary sacrifice, employer contributions and contributions on which tax deductions are claimed. Non-concessional (or after-tax) contributions include sums on which tax has already been paid such as the proceeds of the sale of an investment property or an inheritance or personal savings. Concessional contributions are popular because they save tax, but they may have possible tax implications later.
On retirement, the important metric is the proportion (not the amount) of super that is made of concessional and non-concessional contributions. Before the changes brought in by Peter Costello in 2007, the tax paid on your super in retirement was determined by these proportions. Today, if you access your super before age 60, these tax arrangements are still in place and determine the tax payable. And even today, everybody’s tax liability on their death benefit before any money is paid to beneficiaries is determined by these same proportions.
Taxing of withdrawals based on proportions
Costello’s changes made all super tax free after age 60 for those who are fully retired (or more precisely, those who ‘ceased an employment arrangement’ after the age of 60). Therefore, these proportions have little relevance if retirement is postponed until age 60 or the super fund is exhausted before death.
To check whether Costello’s tax-free super after 60 is overly generous, consider how the tax system works and how little tax was paid on super in retirement before 2007. Tax on super in retirement only ever applied to the concessional portion of the fund, or that portion that claimed tax concessions in the contributions (accumulation) stage.
Let’s assume George today is over age 56 but under age 60. He can access his super, but his super is taxable. This treatment applied to everyone before 2007.
If George retires with $1 million in super made up of $800,000 of employer and salary sacrifice contributions and $200,000 made up of after-tax contributions, then all withdrawals from his super, both pensions and lumps sums, are in the proportion of 80:20. With lump sums, everyone is entitled to take a once-only withdrawal from super of $200,000 as a concessional allowance. So if George were to take a lump sum withdrawal and pay no tax, he could take $250,000 because $200,000 (80%) is his concessional allowance and $50,000 (20%) is seen as the return of his own money that he has already paid tax on.
Please note that these proportions are only examples and everyone will have their own unique proportions. Surprisingly few people know what their proportions are.
Super pensions come with a 15% tax rebate which is compensation for the 15% contributions tax and the 15% tax paid on earnings in accumulation phase. Tax concessions on super pensions were designed to encourage retirees to take their super as an income stream rather than a lump sum which could be spent before claiming the age pension.
These same proportions apply to any super pension George may take. In this example, he can take a pension of $54,000 and pay no tax. His concessional component of the pension is 80% or $43,250 and his non-concessional component is 20% or $10,750. His non-concessional component is tax free because it is the return of his own money. And the concessional component is also tax free because the 15% rebate on $43,250 is $6,487.50, which cancels out the tax liability of $6,468.
Even if George took a larger pension he pays very little tax. If the pension was $80,000 his non-concessional component is $16,000 (20%) tax free, and his concessional (taxable) component is $64,000 (80%). The tax on $64,000 is $13,627 but it comes with a tax rebate of 15% which is $9,600. His net tax is slightly more than $4,000 on a pension income of $80,000 when workers on the same income pay in excess of $19,000 in tax.
Restrictions will limit large balances
With the restrictions on concessional contributions (currently $25,000 per person including both employer and salary sacrifice contributions), it is impossible to accumulate large super balances by concessional contributions alone. It requires the contribution of large amounts of after-tax (non-concessional) contributions from the sale of properties or businesses or from after-tax savings. Before 2007, there was no limit on after-tax non-concessional contributions. With large super balances, it is likely in future that the proportions in retirement super will be heavily weighted in favour of non-taxable benefits.
For the sake of comparison, let’s assume that George’s proportions are now reversed. His concessional contributions are now 20% and his non-concessional contributions are now 80% of his super balance. His tax-free lump sum now is $1,000,000 made up of $200,000 (20%) as his concessional allowance and $800,000 (80%) as the return of his own money.
Even though at his age, his super is subject to tax, he can now take a tax-free pension of $216,250 because we know that 80% or $173,000 of that is tax-free as it is the return of his own money and $43,250 (20% concessional) is taxable. But the taxable portion comes with a 15% rebate which cancels out the tax payable, as before.
Death benefits tax
The tax on death benefits uses the same process. The tax only applies to the concessional component. Therefore, the higher the concessional proportion, the more tax that is payable. The death benefit tax is 15% plus the 2% Medicare levy on the taxable portion. If the super death benefit is an insurance payout, the tax is 30% plus the Medicare levy.
If George died with $1 million in his super and his concessional component was 80% of the total, the tax payable before his beneficiaries received any money would be 17% of $800,000 or $136,000. By contrast if George’s concessional component was only 20%, the tax would 17% of $200,000 or $34,000.
Clearly, the larger the non-concessional proportion, the lower the tax payable on death. Large super balances are more likely to contain a high proportion of non-concessional super. The message is clear: benefits paid from small super balances pay little or no tax and, by definition, large super balances that contain large non-concessional components also pay little or no tax on their benefits.
Costello forfeited little tax revenue
So it was easy for Costello to make super tax-free after 60 because his decision forfeited very little tax revenue and at the same time proved politically popular. No government since 2007 has contemplated reversing that decision. Such a step would be politically unpopular and it would generate little revenue.
It also explains why Treasurer Scott Morrison has capped the amount that can be held in the pension area where the fund income is tax-free. By forcing amounts in excess of $1.6 million into accumulation phase, the government at least collects tax at the rate of 15% on income earned from both components of a super fund, whereas before 2007, the tax only applied to the concessional component.
Whether that $1.6 million cap is too generous is another discussion but a nostalgic return to the golden era before Costello’s changes would generate little or no tax from those funds with large super balances. In fact, that tax regime would collect less tax than the present system.
Jon Kalkman is a former Director and Vice President of the Australian Investors Association. This article is general information and does not consider the circumstances of any investor.