We have now established that a franking credit is part of a taxpayer’s taxable income, and that any taxable income held by the ATO that is excess to the tax liability should be refunded in cash as it is currently. This whole franking credit debate has highlighted the refunds that flow to super funds because of the tax concessions they enjoy.
Many readers have blamed Peter Costello’s changes in 2007 for making super tax-free. This is incorrect.
With super, it is fund that is the taxpayer, not the member
Super was designed to help accumulate a nest egg for retirement to supplement or replace the age pension. It works with the cumulative effect of contributions added to investment earnings over 40 years less fees and taxes while no withdrawals can be made before retirement. The fund, not the member, pays 15% tax on (concessional) contributions, 15% tax on investment income and 10% tax on capital gains. The fund is a single taxpayer, paying tax on behalf of all its members. Therefore, with shares, the fund is the shareholder and taxpayer, not the member.
In retirement, most people transfer their super balance to a pension account because of its preferential tax treatment. A super fund paying a pension pays zero tax on income and capital gains. That has been the case since Paul Keating introduced universal and compulsory super in 1992. Keating could have left contributions and investment income tax-free if he taxed the benefit stage (pension and lump sums) normally, but he was not prepared to wait 30 to 40 years before collecting any tax.
Tax-free status of pensions is a reward for compulsory saving
Keating recognised long ago that Baby Boomers would be a great strain on the public purse in retirement (from 2011 onwards) unless they saved for their own retirement. The tax-free status of the pension fund has always been seen as compensation for compulsorily forcing people to lock their money away for 40 years. It is an encouragement for people to save for their own retirement and thus becoming less reliant on the age pension. The deal Baby Boomers were sold was that, after paying tax on contributions and investment income for 40 years, they would have tax-free pension funds.
Younger people and politicians who were not party to that social contract are often surprised and somewhat offended that super funds should be tax-free in retirement, and they blame the then Treasurer, Peter Costello, for making super tax-free after 60 in 2007. They are mistaken. The tax on earnings (income and capital gains) inside a pension fund has been zero and unchanged since 1992. This includes the time when Costello made withdrawals from a super fund, tax-free (after age 60) in 2007, when Mr Shorten was Minister for Superannuation in 2010, and when Treasurer Morrison limited the size of a tax-free pension fund to $1.6 million, in 2017.
Under Keating’s original plan, members would still pay tax on benefits taken from a fund in retirement but only on the concessional portion of that benefit and then only after a 15% tax rebate to compensate for taxes already paid. Consequently, very little tax was collected from this source. This is the tax on member withdrawals that Costello eliminated in 2007 and no government since has tried to reverse that decision, simply because the potential tax collected is not worth the political pain.
Costello’s changes did not affect the tax on super funds.
Part of the deal with a super pension is mandatory withdrawals
Members in a super pension fund have an obligation to take a mandatory minimum pension withdrawal every year in cash and that mandated minimum increases with age. It means that assets must be progressively sold to satisfy that pension requirement. The effect is to progressively deplete the fund to reduce or eliminate concessional super being passed to beneficiaries on death. In fact, many people exhaust their super balance well before that time.
Impact of franking credits in super
Australian shares are the only class of assets where the income arrives in the hands of the owner with tax already paid (that is why it is called franking), and will generate franking credits for the fund just like it will for other shareholders. The fund is a single taxpayer, paying tax on behalf of all its members. Under Labor’s proposal, if a fund has members predominantly in accumulation phase it will have a tax liability and it will be able to use its franking credits to pay some or all of the fund’s tax liability but there will be no cash refund for any excess franking credits. The fund’s final tax position depends on income from assets other than shares and the number of members still in accumulation phase with tax obligations on contributions and investment income compared to the number of members in the tax-free pension phase.
Retirees in pension phase in an industry fund may find that the fund has sufficient members in accumulation phase to allow their super pension to continue to receive a refund of their franking credits at least until the fund is overwhelmed by the number of members in pension phase. Such a policy is easily overturned.
SMSFs typically only have a couple of members, both in pension phase and the fund has no other tax liabilities to absorb franking credits. Under Labor’s proposal, the fund will lose all its franking credits refunds, or up to 30% of its income depending on the fund’s allocation to shares.
It is sometimes suggested that pension funds should be taxed the same as accumulation funds. Such a tax would certainly collect a lot of money because it would apply to income from all assets in the fund, not just shares, and it would apply to all super pension funds, SMSFs and industry funds alike. It would avoid the perceived discrimination of Labor’s proposal against SMSFs, but no one would then use a pension fund with its mandated requirement to remove assets from this concessional area, and that has estate planning implications.
If retirees remain in a pension fund, Labor’s proposal will seriously impact the fund’s capacity to continue to pay the mandated withdrawals because it will have lower after-tax earnings. When the super fund is exhausted, most people become reliant on the age pension, at least in part. Labor appears not to have considered that their proposal has severe long-term implications for the cost of the age pension to the taxpayer.
Jon Kalkman is a Director of the Australian Investors Association. This article is for general information purposes only and does not consider the circumstances of any investor.