Speak to a lot professionals in the industry and ask them what the biggest change was as a result of Simpler Super? The most common responses were either tax-free pensions from age 60 or the abolishment of RBLs. Whilst these were significant, the reality was that most pension recipients being structured correctly were paying little or no tax anyway (as a percentage of every dollar of pension paid).
To me, the biggest change was the restructuring of superannuation components, and in particular, the introduction of proportions to income streams. The proportion rule, basically ‘locks-in’ the tax-free and taxable component at the commencement of an income stream. So what is so special about this?
To put it into some context, let’s use a simple example…
John, 60 years of age, commences a pension with $1 million. He has 50% ($500k) as tax-free component and 50% as taxable component. In the Simpler Super world, the commencement of the pension would form a 50/50 proportion between the tax-free and taxable components. These proportions will remain throughout the life of this pension (unless rolled back to accumulation). In the pre-1/7/07 world, the $500k would form the Undeducted Purchase Price (UPP) and would reduce each year by a deductible amount. The deductible amount was $23,084 ($500k/21.66 life expectancy).
Let’s move forward 10 years… fortunately for John over that time, his account balance has grown slightly to $1.2 million. Under the pre-1/7/07 rules, the tax-free component of his $1.2m benefit is now $269,160. Under the Simpler Super rules, the tax-free component (stated as a proportion) is now $600,000. In 10 years, this is a $330,840 difference!!
Let move forward 20 years… prudent investing still has John’s balance at about $1 million. Under the pre-1/7/07 rules, the tax-free component would now be $38,320, meaning 3.83% of the total benefit is now tax-free. This is in contrast to a 50% proportion still applying to the Simpler Super pension, meaning $500k is tax-free. This represents a $461,680 difference!!!
So, why is this important?
From an estate planning point of view, the introduction of the proportion rules quite simply leaves more money in the estate when assets pass through to the next generation. Using the 20 year difference of $461k, this represents a potential increase to the estate (or where directly paid to beneficiaries) of between $69,000 – $76,000 plus dollars (depending on how it’s ultimately paid).
Therefore, in an SMSF environment, it can become quite a useful tool to start dissecting a member’s interest once converting from accumulation phase into drawing an income stream. This is usually achieved through a recontribution strategy where the member has no cashing restrictions (e.g. retired). It is important to remember, there is a fantastic window of opportunity for strategy opportunities between 61 up to 65 to reweight the tax-free and taxable components of an SMSF member.
Going back to our example, if John was able to undertake a recontribution strategy before commencing any pensions, he could withdraw and recontribute $450,000. His components would now show $725,000 tax-free and $275,000 taxable component. However, importantly, you would consider running a multi-pension strategy whereby the $450,000 recontribution would become a second pension, made up entirely of tax-free component (100%). Therefore, John would have two pensions, (1) $550,000 – $275,000 (50% TF) / $275,000 (50% TC), and (2) $450,000 (100% TF).
What is the importance of setting up these multi-pensions? Well, there are a few reasons:
- Where John is taking more than the minimum pension, he can elect to take more from the income stream that has a higher taxable component. Why? Because it will eradicate the taxable component pension quicker. This leaves a greater slice of the pie for the beneficiaries and less for the taxman!!
- Subject to John’s remaining beneficiaries, he may wish to direct the different super interests to different beneficiaries. This is particularly powerful with blended families where they may be a dependent spouse (2nd spouse), but you want kids from the first marriage to receive money on your death.
- If John was under age 60 (55-59) and drawing an income stream, he could select to take amounts from the 100% tax-free pension and not have any assessable income to declare. This allows for greater tax efficiency than running a single interest, where a proportion of the benefit would be subject to tax.
I must admit, I found it quite staggering at the time that this Simpler Super rule change came into effect on 1 July 2007. The potential black-hole in government revenue from this change must run into the hundreds of millions of dollars, maybe even billions as superannuation grows. Government projections of $3 trillion of super assets by 2025 must certainly mean this law change is too good to be true?
With the final report from the Henry Tax Review due out next month and knowing superannuation is going to get the ‘once over’ in this report, it will be interesting to see whether this change was too good to be true or whether multiple pension strategies should continue as a powerful SMSF strategy.