In my article and subsequent comments about Labor’s proposed removal of franking credits for shareholders on a zero tax rate, I’ve not addressed whether the system should change to make the targeted retirees pay tax. I’ve said merely that if that’s the goal, then it should be addressed directly through a change in their tax rate, not through the back door of the imputation system change.
However, much of the discussion about this policy is focussed only on the alleged wealth of these retired folk with their multi-million dollar SMSFs and six figure pension payments. If that’s all that is said about them, then it’s an easy ‘social justice’ argument to say that they’re benefitting from a rort and should be made to pay more tax.
I don’t believe this thinking is correct. Everyone should understand how such retirees reached the current situation and what is actually fair in terms of their taxation.
How are large SMSF balances accumulated?
Let’s look at BB (for Baby Boomer) who has $1.6 million in their super fund. We need to understand clearly where that money came from and what tax BB has already paid on it.
The first source is the contributions under the Superannuation Guarantee paid by BB’s employers. This was taxed at 15% when it was invested. At the very least when this is withdrawn, whatever tax rate BB is on should be reduced by that 15% or BB will be double taxed.
The second source was non-concessional contributions, paid by BB out of after-tax salary. This money has already been taxed at BB’s full tax rate. There should be no more tax on this withdrawal or BB will have been double taxed.
The third source is income that’s been earned on the investments in the fund, which will of course largely be compounded earnings. This has also been taxed at 15%, so whatever BB’s current marginal rate is, these withdrawals should be taxed at least 15% less.
OK, the $1.6 million from accumulation mode now goes into a pension account and is split into those three components. For simplicity, let’s say that 25% comes from non-concessional contributions, 15% from concessional and the rest from accumulated earnings. When BB makes a withdrawal from this fund as a pension payment in retirement, the tax already paid needs to be recognised in any tax obligation.
Let’s say BB immediately withdraws $100,000 upon retirement. The most tax that should be levied on that amount should be:
- Zero on the $25,000 that is the proportionate withdrawal of the fully taxed non-concessional contributions
- BB’s marginal tax rate minus 15% on the $15,000 from concessional contributions
- BB’s marginal tax rate minus 15% on the remaining $60,000 of accumulated earnings.
If BB is in, say, the 32.5% marginal bracket from other earnings when this withdrawal is made, then this means a tax rate of 17.5% would apply to $75,000, which is 13.125% of the $100,000 amount.
The tax incentives have a social purpose
The money was invested into super because of the promise of a tax-effective long-term saving vehicle to fund retirement rather than drawing an age pension from the public purse. During the 1980s in particular, we faced projections of an ageing population that would become a burden on the budget because of age pension requirements. We also had a current account deficit that was portrayed as a domestic savings deficiency (e.g. in Vince Fitzgerald’s report on National Saving).
This social contract is not the result of a conspiracy against Gen Ys or other younger people in 2018! It is based upon sound economic and fiscal policy thinking. More retirees will fund their own lives rather than Gen Y’s taxes having to be even higher to pay more old age pensions.
The flat tax rate of 15% on earnings within a super fund is one way the social contract is expressed in policy, as it’s lower than the marginal rate for many investors. The system also provides for a lower than normal marginal tax rate on withdrawals in retirement. This means that the tax rate when those accumulated funds are drawn should be discounted by more than the 15% tax already paid.
Thus, for BB, the tax on this $100,000 withdrawal from their fund should be less than 13.125% to honour the social contract that led them to defer spending their income earlier in life. The current regime levies zero tax on withdrawals for those over 60 in retirement. It’s a tax discount that for BB is approximately 13%, but would be a bit more or a bit less depending on the exact mix of the source of the funds.
The message to those who think this is unfair on subsequent generations is simple: it’s not a rort but a perfectly fair arrangement for those who’ve saved the way they’ve been urged to by the government. Tax has already been paid and to demand that full tax be paid again now is not only unwarranted, but would be punitive.
Limits placed on the amount in superannuation
We’ve also had policies to limit super, such as reasonable benefit limits and contribution caps. The superannuation system allows ordinary folk to accumulate a reasonable amount to fund their retirement, but not give the wealthy a tax haven. Peter Costello opened the window too much 10 years ago, but that’s been closed now with the $1.6 million cap – a perfectly reasonable policy change, albeit disappointing for those who had counted on the previous level of generosity.
Furthermore, those who earn more than $250,000 per annum (until recently this threshold was $300,000) pay 30% on their contributions, not just 15%. If our friend BB was in this camp, then the calculation above of how to tax a $100,000 withdrawal from their fund means 2.5% on $15,000 plus 17.5% on $60,000, which is 10.875% of the $100,000 amount. The tax discount in the current tax-free regime is thus only a discount of about 10%.
Of course, nothing is ever that simple. The $1.6 million that BB has built up in a pension account will now earn income that is tax free in the fund. Therefore, an ongoing stream of cash flow to BB out of the fund will include components from that income. Even then it may also include a component that is withdrawing from the accumulated $1.6 million that should be taxed at no more than 17.5%.
Tax treatment on income in pension account
Let’s say that BB is between 60 and 65 and draws a pension of 4% a year, or $64,000 from the $1.6 million. How should we think about this payment? The answer depends on what the fund’s income earnings have been.
If the fund earned more than 4% in income, then all of the $64,000 should be treated as being paid out of investment earnings that have not yet been taxed. At the moment the rule is that this is tax-free to BB. If the ordinary personal income tax scale was applied to this amount, however, then BB would be sitting in the 32.5% marginal tax bracket and pay $12,347 in tax. This is 19.3% of the income. Some untaxed earnings would remain in the fund.
If the fund earned less than 4% in income, however, then a portion of BB’s $64,000 payment is drawing down capital and the calculations above should apply to that portion, which would result in an overall tax rate of less than 19.3%.
Fairness, therefore, calls for no more tax to be levied on retirement incomes than these sorts of amounts, which will of course vary from person to person. My own view is that, it’s simpler and honours the long-standing social contract with BB to just stick with the tax-free arrangement we have at present on this relatively modest amount. Average weekly earnings at the moment are running at around $88,000 per annum, so a pension account income of $64,000 does not make BB a wealthy person!
People who have money in super over and above the $1.6 million that can be put into a pension account face, rightly, a higher tax obligation when they withdraw from that excess amount. Again, recognition should be given to the tax already paid on the money that they have invested in super, but calls for full marginal taxation of withdrawals from super funds are wide of the mark.
The reality is that when people draw an ‘income’ from their super, it’s not the same as earning more dividends or interest or rent that hasn’t had tax paid on it yet. Much of it – especially later in life when the required withdrawal rate is well above interest and dividend earnings rates – is simply withdrawing from a pool of contributed capital and investment earnings that has already been taxed at an appropriate rate. The boundaries already in place, such as the $1.6 million cap on the size of that pool, are adequate to restrain any ‘rorting’.
I’m not a tax expert. I’ve checked everything in this article with the ATO website, but no doubt there are nuances I’ve missed.
However, I hope that the framework I’ve outlined can serve the interests of an informed discussion about appropriate tax policy towards self-funded retirees rather than the class and inter-generational warfare arguments that have been too prevalent. What we want is a fair tax system and decent retirement income policy. We have a better chance of getting those outcomes if we base our discussions on facts and not emotion.
Warren Bird is Executive Director of Uniting Financial Services, a division of the Uniting Church (NSW & ACT). He has 30 years’ experience in fixed income investing. He also serves as an Independent Member of the GESB Investment Committee. These are Warren’s personal views and don’t necessarily reflect those of any organisation for which he works.