Much is made of retirees who pay no tax but also receive a tax refund. This view demonstrates a fundamental confusion about how the super system works. Any income generated by an asset belongs to the owner of the asset who is responsible for the tax on that income. In the case of retirees with a SMSF, the owner of the fully franked shares is the SMSF, not the retiree. The retiree is the trustee of the fund with a fiduciary duty to all members of the fund, some of whom may not be retired. As a separate taxpayer, the SMSF has a tax file number and completes a tax return after the fund has been audited.
If the SMSF is an accumulation fund, it pays tax at the rate of 15% on income and concessional contributions. At present, some of the imputation credits help to pay that tax. Any excess imputation credits are presently returned as cash to the fund and this adds to the income produced. It is typically reinvested to grow the fund for future retirement needs. The same applies to retail and industry super funds. No money is withdrawn because super cannot be accessed before retirement.
If the SMSF is paying a pension, the tax rate is presently zero. This also helps to increase the income produced by the fund. This is also true of retail and industry super funds. Since 2007, withdrawals from the fund (both pensions and lump sums) have been tax-free.
Implications for withdrawals
There is no limit on the maximum withdrawal from a super fund. It is possible for a retiree to withdraw their whole super balance at any time. In fact, many people with small super balances do just that as soon as they retire. It may pay off their mortgage or have other uses without interfering with their claim for the age pension.
Retirees, whose assets exceed the assets test and are therefore ineligible for the age pension, will want their super fund to sustain them for as long as possible. The more they take, the quicker the fund is depleted. When their super fund is depleted, most retirees have no choice but to claim the age pension. As most people regard the age pension as only a basic standard of living, most self-funded retirees would want to delay that date as long as possible.
The other problem is that once money is removed from the tax-advantaged area of super, the contribution rules make it difficult to put it back in. Therefore, in order to sustain the super fund for as long as possible, most retirees take no more than the minimum they need or the mandatory minimum required. For the pension fund, the secret to long life is a higher investment return and a lower drawdown rate. In the pension phase, the government assists by reducing the tax rate on investment earnings to zero. The purpose of any super pension fund is to fulfil its assigned task of delaying the member’s claim on the government age pension, possibly indefinitely.
Some countries choose to collect no taxes on contributions or earnings in the accumulation phase but then tax retirement benefits at normal rates. When universal super was established in 1992, the Australian government was not prepared to wait 30 years before it collected tax so it chose instead to tax contributions and investment earnings in accumulation but made the retirement phase tax-free. Either way the aim was to make it possible for the fund to provide retirement benefits for as long as possible.
The catch, of course, is the minimum pension which at age 55 is 4%, rising to 14% of a member’s super balance from age 95. These mandatory withdrawals force retirees to progressively sell assets for cash to satisfy the pension requirement thus depleting their super balance over time. This ensures that money is removed from super and exposed to normal tax. It also reduces the balance of tax-advantaged super, if any, remaining at death that is passed on to dependents.
Australian shares provide an excellent income in retirement. The much-publicised volatility of share prices only requires management if shares are traded. If shares are not traded, an SMSF’s income depends on dividends. The income does not rely on the sale of units with volatile market prices, as is the case in an industry super fund providing a pension.
Removal of the cash refund for excess imputation credits will reduce dividend income to an SMSF by up to 30%. Lower investment returns in the super pension fund means that more assets will need to be sold to meet pension requirements, and that hastens the fund depletion. This policy will cut the lifespan of an SMSF pension fund by many years, depending on its shareholdings.
This makes no difference to the tax-free nature of the withdrawal a retiree takes out the fund.
Periods of low investment returns
The evidence from the GFC is clear. This period of low investment returns had a devastating effect on many super pension funds. The government response to the GFC was to halve the minimum pension requirements. That was useful for those who could afford to live on a smaller pension, but for many who had to maintain their lifestyle, selling all those assets at depressed prices slashed years off the life of their fund. Those lost assets can never be regained because a pension fund cannot accept more contributions.
It is disingenuous and misleading to suggest that some retirees pay no tax but still get a tax refund. The cash refund for imputation credits is received by the fund, not the member. The tax status of the fund is independent of the member’s tax-free cash withdrawals, which are governed by the member’s age and their income needs.
We are facing a tsunami of baby boomers reaching retirement along with their increased life expectancy. We could face a situation where people in their 90s, as well as their children, claim the age pension at the same time! It is short-sighted and financially reprehensible to guarantee that more self-funded retirees will become dependent on the age pension much sooner than they otherwise would. Policy makers need to understand this.
Jon Kalkman is a former Director and Vice President of the Australian Investors Association. This article does not consider the circumstances of any investor.