The myth about Costello’s super generosity

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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.

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25 Responses to The myth about Costello’s super generosity

  1. Dee August 12, 2018 at 10:29 PM #

    mmmm
    When does this total cap start from ?
    Meaning if you are still at work and for example your super balance was 2.3m.
    Are you saying it is only permissible to hold $1.6m in super and $700 will need to be held outside super ?

    Or

    Is it only the arithmetic sum of super after Morrison’s law was passed ?

    • Jon Kalkman September 8, 2018 at 9:14 AM #

      Dee
      The law has already come into effect from 1 July 2017. It means that you cannot have more than $1.6m in the tax-free pension area when you retire. That is true even if you inherit your deceased spouse’s super pension. Any excess super cannot be in a pension fund. Most people put the excess back into a concessionally taxed accumulation fund.

      It also means that if your total accumulation fund super is already over $1.6m before you are retired, you cannot make any more non-concessional contributions. Contributions contributions such as Super Guarantee and salary sacrifice contributions are permissible up to the limit of $25,000 per year but the $100,000 per year contribution of after-tax money cannot go into super.

  2. Patrick June 10, 2018 at 2:50 PM #

    Jon, “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.”
    Do you mean in answer to Kari’s question, the following should be taken into consideration.
    a) Before the transfer of $1.6 K in 2017, the pension paid no tax on its income and paid no tax on contributions as contributions were not allowed to a pension fund.
    b) After the transfer of $1.6 K to the accumulation fund after 01/07/17, the fund now pays tax 1) at 15% on its income and 2) at 15% on any further contributions to accumulated fund where these are allowed?

    • Jon Kalkman June 11, 2018 at 9:33 PM #

      Patrick, by way of illustration assume George had $10million in pension phase before 2007. His pension was taxable but because his non-concessional component was so high (that is the only way you could get such a large super balance – by putting large amounts of your own after-tax money in) his pension was essentially tax-free – as described in the article. But theoretically his concessional component is still taxable.

      The income earned by the fund in pension phase has always been tax-free. After 2007 the pension that George withdrew from that fund was completely tax-free, regardless of components, – courtesy of Costello’s changes – because all super withdrawals (pensions and lump sums) from that date were tax-exempt. If George is aged between 65 and 75 his minimum pension is 5% so he receives a tax-free pension of $500,000.

      Fast-forward to 2017. George can no longer hold $10 million in his pension account. He can only hold $1.6million in a pension account. The remainder is either removed from super altogether or moved back to accumulation phase. As the tax in accumulation is lower than outside super, most people have moved their excess super from pension phase into accumulation. He is still required to take a minimum pension of 5% from his pension fund because of his age, so now his minimum pension is $80,000 (5% of $1.6m). Note that is the minimum, there is no maximum.

      From the government’s point of view, George now has $1.6million in his pension fund, in which the fund pays no tax and neither does George when he takes his pension. But now George also has $8.4million in a separate accumulation fund where the income is taxed at 15%. If we assume this accumulation fund earns 6%, the fund’s income is $504,000 and the tax payable by the accumulation fund is $75,600. That is why Morrison collects more tax from George’s super than Costello ever did, certainly not after 2007 and not before 2007 either.

      By the way, because there is now a cap on total super, you will not be able to accumulate more than $1.6m, which is also the limit on the size of a pension fund. So in future, it is unlikely that there will be any super in excess of this amount held in accumulation phase, taxed at 15%. Instead, savings in excess of $1.6m will be held outside super altogether where the income will be subject to normal tax. Again, Morrison has introduced a limit on the concessional tax applied to retirement income that did not exist before 2007 under Costello.

  3. Hari June 8, 2018 at 3:27 PM #

    “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.”

    Can you please clarify this? Taxation on super earnings was essentially the same pre and post 2007 until 2017. 15% tax during accumulation and 0% tax during pension (mixtures of the two dealt with actuarial certification)

    Saying that pre-2007, taxation within super only applied to earnings on the concessional component of an accumulation balance is incorrect.

    • Jon Kalkman June 8, 2018 at 7:20 PM #

      Hari, it is very important to distinguish between:
      a) the tax paid by the super fund – which has always been 15% in accumulation phase and 0% in pension phase – and;
      b) the tax paid by the member of the super fund when that member take a retirement benefit from the fund – which changed in 2007 and was the subject of this article.

      Of course if we are talking about franking credits we also have to talk about the tax paid by the company on behalf of the shareholder. And with super, the shareholder is always the fund, not the member.

      It is this confusion about who is responsible for which tax that is the cause of so much misunderstanding and misinformation in this debate.

  4. Ramani June 8, 2018 at 12:46 PM #

    Jon- thanks for the detailed reply.

    Based on what you say, the idea will work: while still alive but lacking capacity, the Enduring POA-holder decides to withdraw the remaining partner’s super in full and credit it to his / her bank account making it part of the eventual estate, avoiding the 17% tax that would apply if distributed directly from the super fund into a non-tax dependent, right?

    Where the rules provide for two different ways of action, both legal, can the taxpayer (or estate) be pursued for taking one way rather than the other, merely because it leads to a better outcome? I hope not, because in that case people who slaary sacrifice into super instead of taking it in cash are doing the same.

    • Jon Kalkman June 8, 2018 at 2:11 PM #

      Ramani. I am not a lawyer so I cannot give legal advice. As you say, it is perfectly legal to withdraw any or all of the money from super, tax-free, after age 60, for any purpose. That is may be no need to wait for the estate administration after death.
      But I am sure that the trustee of the super fund would want to be very sure that the EPA had the legal authority to make such an irreversible decision on behalf of one of their members. As we know, elder abuse at the hands of EPAs is on the rise.
      The decision is irreversible because members cannot make contributions to super after age 65 unless they pass the work test and then only up to age 75.
      I suggest you get your own legal advice.

    • Craig June 8, 2018 at 3:53 PM #

      Ramani – I think I would be very cautious about advising someone to pull money out of super under an EPOA. Under the various state laws someone holding an EPOA must act in the best interests of the donor. How is pulling benefits out of super prior to death in the best interests of the donor? Especially if it results in additional tax liabilities on any income earned prior to death?

      I get that it could save tax if benefits end up being paid to adult kids – but that benefits the kids, not the parent.

      Also what would happen if pulling money out resulted in the super death benefits being paid to a different beneficiary than was intended. For example, what if there was a binding nomination in place saying pay death benefit to A but under the will or laws of intestacy it ended up being paid to B? I think there could be a few interesting questions asked by A’s lawyers in that situation.

  5. James June 8, 2018 at 9:38 AM #

    The article focuses on the withdrawal rules for an individual under 60. Is it true that by July 2024 the age preservation age for all will be 60 years of age, so the withdrawal rules for under 60 will not apply, and all withdrawals and pensions drawn from Super will be tax free?
    The changes to super in 2007 involved a simplification of the complex super rules, moving from 8 different types of contributions to 2. This is very handy when explaining super to the general public. However, the introduction of transfer balance caps (TBCs)and total super balances (TSBs) in 2017 has added back complexity to the super process.
    TBCs and TSBs were created because some super funds had very large balances in their accounts, and this was regarded as overly generous. An individual with $10m in their account based income stream could get a tax free annual pension of a minimum of $500,000 at age 65.
    If Treasurer Costello had set up a lifetime cap in non-concessional contributions in 2007, would this have prevented the need to create TBCs and TSBs?

    • Jon Kalkman June 8, 2018 at 12:31 PM #

      James, the changes in 2007 did introduce caps on non-concessional contributions. Before 2007, there was no limit on non-concessional (after-tax) contributions. That is why some funds still have more than $10m in them. At first Costello limited these non-concessional contributions to $150,000 but after the screams of unfairness he limited them to $1m but only for the first year. After that the limit was set at $150,000 but by using the bring-forward rule, you could put in 3 years worth at once but no more for 3 years. There was no life-time cap.
      This was then indexed up to $180,000 or $540,000 over 3 years. The changes brought in by Morrison now limits these non-concessional contributions to $100,000 or $300,000 over 3 years.
      As the concessional contributions are now set at $25,000 for everyone (it used to be higher for older people to allow them to catch up) it will now take you 40 years to contribute $1m in concessional contributions.
      What we have now is essentially a new Reasonable Benefits Limit (RBL) and no one will be able to accumulate more than $1.6m. If you already have that much you cannot put any more non-concessional contributions.

  6. Ramani June 7, 2018 at 10:07 PM #

    Would it be acceptable for a couple in pension phase with adult non-tax dependent children appoint one or (as many) of them as the holder of an enduring power of attorney, with explicit instructions to the attorney to cash out all the balances when the terminal time of the survivor of the couple arrives?
    Upon the death of a partner, the remaining partner gets the balance tax-exempt (either as lump sum, or reversionary pension which may need their own pension to be commuted to stay within the $1.6 million pension balance cap). When the remaining partner dies the attorney would have cashed out the superbalance and taken it out of the system avoiding the death tax.

    • Jon Kalkman June 8, 2018 at 10:41 AM #

      Ramani, the best way to avoid the death benefits tax is to make sure the super fund is exhausted before you die. If you are over age 60 you can empty the super fund without tax at any time. If you have a terminal illness that might work. If your death is unexpected then any super remaining is taxed as set out above.

      You give your power of attorney the authority to act on your behalf while you are still alive and you would do that in case of incapacity or infirmity. If you do not have a power of attorney in an SMSF and you are faced with incapacity or infirmity, as no one has authority to act on your behalf, you may find that the Public Trustee is appointed by the court to act. That is why everyone with a SMSF should have a power of attorney.

      Once you are dead, your power of attorney has nothing more do with it. If you are in a public offer fund, on your death, the trustee has the authority to distribute your death benefits according to the trust deed and your wishes. In a SMSF the critical question is: “who is the trustee after your death and are they bound by your wishes”? This is where binding death benefits nominations come into play.

      One of the eligible beneficiaries of your super is your estate where your executor will then be distribute your super assets according to the provisions of your will. That is the only way you could pass your super death benefits to your grandchildren. But passing it through your estate does not change the tax liability. The tax payable is always determined by the tax-status of your final beneficiaries and according to the components set out above.

  7. Leo June 7, 2018 at 4:46 PM #

    What remains incredible is that these pensions are not only tax-free after age 60 but also not declarable as income. So any other income received, via investments or wages, starts from $0 for tax purposes.

    IMHO that is overly generous.

  8. Maurie June 7, 2018 at 2:00 PM #

    Thanks Jon,

    The taxing of the death benefit withdrawal interests me. When the recipient is a non-tax dependent, only the taxable component is impacted. My understanding is that all earnings derived during accumulation phase are treated as a taxable component irrespective of its source (concessional or non-concessional contributions). In contrast, the earnings derived during pension phase are allocated according to the taxable and non-taxable proportions that prevailed at the time of entering pension phase. If all earnings in accumulation are treated as taxable, the non-concessional component of the balance at the time of withdrawal or entering pension phase must be diluted. The earnings derived from this source do not retain the tax status of its source. Under the current system, the dilution effect doesn’t mean a whole lot for a person approaching 60 and entering the tax-free pension world. However, when unused super entitlements pass to a non-dependent (i.e. grandchildren) upon death, the scale of earnings derived during accumulation phase will impact on the components (taxable and non-taxable) of the ultimate death benefit. Admittedly, the dilution effect is frozen once you enter pension phase. Nonetheless, it may come back to haunt again if retirees in pension phase feel inclined to move back into accumulation phase as a response to the 2017 pension cap or the possible changes to dividend imputation as mooted by the ALP.

    • Jon Kalkman June 7, 2018 at 2:58 PM #

      Maurie, you are quite right. When you start a pension the proportions of concessional and non-concessional contributions are frozen for the life of the pension, because a pension cannot accept any more contributions. If you turn the pension back into accumulation (called a commutation) presumably to add more money so that you can have a bigger pension, you also change these proportions for the start of the new pension. Starting a new pension may also have Centrelink implications.

      If you choose to remain in accumulation phase (and have your fund pay 15% tax on the fund’s earnings but without the obligation to take a minimum pension that increases with age) the proportions change all the time, because, as you say, while your contributions may remain unchanged, the annual fund’s earnings continue to add into the non-concessional portion and therefore potentially add to the death benefit tax.

      The eligibility of beneficiaries to a super death benefit is complex and worth further investigation. Suffice to say, a spouse can receive this benefit tax-free either as a lump sum or pension, adult children pay tax as described above and grand children are not eligible at all.

  9. Craig June 7, 2018 at 1:45 PM #

    I agree Costello’s tax free super from age 60 was largely smoke and mirrors due to the impact of the 15% pension offset wiping out tax on pension payments. However, it should be noted this was largely due to the immaturity of the super system at that time. That is, to pay tax on your pension payments pre 1 July 07 you needed to have accumulated enough in super to generate enough income in retirement to push you into the higher tax brackets. Depending on what return assumptions you used this figure changed but it was generally north of approx. $650k based on prevailing marginal rates at the time. Given SG only kicked off in 93 not that many people were actually in that position – therefore no material revenue loss. However, as the system matures and people start retiring with larger and larger balances the revenue losses start getting real.

    • Jon Kalkman June 7, 2018 at 2:14 PM #

      Craig, when compulsory super was introduced, the Keating government had the option of following the lead of other countries. That is, they have no tax on contributions, no tax on accumulation phase and then retirement benefits are taxed at normal rates. It makes so much sense to encourage the accumulation of the largest nest egg before retirement and then treat everyone equally for tax-purposes.

      But the then government was not prepared to wait 30 years before it collected any tax so the compromise was the complexity we have now. Concessional contributions are taxed at 15%, Non-concessional contributions are not taxed. All the income (from both components) are taxed at 15% in accumulation phase (capital gains are taxed at 10%). For all funds in pension phase, the tax paid by the fund on income and capital gains is zero. Before 2007, the tax paid by a member on a withdrawal from the fund depended on the components described above. The super pension carried with it a 15% tax offset as compensation for the tax paid on contributions and tax paid on income in accumulation and lump sums were also concessionally taxed. Since 2007 it is all tax free for those are fully retired.

      So, the 15% rebate on a super pension has nothing to do with the tax bracket you are in or the accumulated super you have before retirement. And for those people under the age of 60 and for death benefits it is still the proportions of the concessional and non-concessional contributions and not the amount of super that counts.

      • Craig June 7, 2018 at 4:01 PM #

        Hi Jon – comment about marginal tax rates relates to fact that post 83 component of pension payments was included in assessable income (as taxable component is now under age 60). Therefore, as the amount of taxable income you received from your super pension increased you started to get pushed into higher tax brackets and therefore the impact of the 15% offset became less and less until you started to have to pay tax. I recall doing the figures back prior to 07 and based on the marginal rates the effective tax free threshold taking into account the 15% offset was somewhere around 40k (assuming 100% post 83 component). If you assume a 5% draw down rate someone would need approx $800k before they started paying tax on the pension payments. How many people had super balances > $800k 10 years ago? Not that many as SG simply hadn’t been around long enough. That’s why I agree Costello’s tax free super post age 60 was smoke and mirrors. However, as the system matures and people have accumulated more as they have participated in the system longer you will get more people retiring with larger balances – which will then start to impact revenue compared to the old system. I am 48 and I remember thinking back in 07 I will never get tax free super at age 60 as by the time I get there it will be costing too much and the buggers will change the rules.

    • Steve June 7, 2018 at 10:52 PM #

      Hi Craig,

      It is a good point you raise. If we still operated under the pre-2007 rules, I figure that the post-1983 component would now be 99% of the entire superannuation asset pool and growing. All those retirees with current pension accounts exceeding $800k would be making a contribution to tax collections (assuming the pension rebate remained fixed at 15%). That contribution may have been diluted somewhat due to tax cuts in the intervening years. However, the old system would have ensured that the greater the pension balance, the greater the taxable component of earnings reported in retirees tax returns and hence, the greater the contribution made to tax collections by the retiree. One may accuse Mr Costello of being a bit short-sighted in his motives for the 2007 policy shift (an ageing government facing the ever increasing threat of a new contender). Who knows, if the old system still existed today, there would not have been a need to introduce a $ cap of tax-free pension balances or alter the dividend imputation rules. Of course, we have the benefit of hindsight.

  10. JENNY SCOTT June 7, 2018 at 1:45 PM #

    at my death my SMSF goes to my Estate(/Testementary Trust). What are the advantages of (as some suggest!) cashing all the share holdings in if given advance notice of my death!? The benficiaries are my adult children and believe saves them tax! My SMSF is in Pension mode & all non-concessional.
    Jenny

  11. simon hunter June 7, 2018 at 11:45 AM #

    I find it highly ironic that the tax on death benefits also includes a Medicare levy!

  12. Steve June 7, 2018 at 11:40 AM #

    I believe there is no “death benefits tax” payable if the beneficiary is his spouse.

  13. Michael Janda June 7, 2018 at 11:29 AM #

    The main take home message I get from this article is that Australia’s superannuation system is way too complex and still allows retirees to have considerable tax-free income streams.

    • F Di Lorenzo June 7, 2018 at 3:10 PM #

      The question is not whether reverting to pre 07 would raise more tax but whether we think it

      “fair ” as a society to not pay income tax after age 60?

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