Simpler Super from 1 July 2007 introduced sizable changes to the superannuation landscape including the abolition of RBLs, tax-free withdrawals for people 60 and over, streamlining of pension types, contribution caps and so on.
These changes all attracted a significant amount of media as they provided some serious tax savings for certain individuals. For example, for some people who were effectively “over-funded” in super because they were in excess of their Pension RBL limit were significantly advantaged. In addition, for many baby boomers (and their parents), from 1 July 2007, they were no longer required to lodge an income tax return as their pension was no longer assessable.
These changes certainly brought with it an attractiveness to superannuation and the need to give appropriate consideration towards your retirement.
So, what did I think was the biggest change in the Simpler Super reforms?
Whilst many people focus on abolished RBLs or tax-free withdrawals after 60, I believe that the most dramatic change on the superannuation landscape was the introduction of proportions into superannuation income streams.
I still actually scratch my head when I consider how the government changed the way superannuation components now exist and apply. To understand it is to realise the power of a range of wonderful strategies for clients to consider, including running multiple income streams and segregated pension strategies.
What are the proportioning rules?
Within superannuation, a members balance is broken up into tax-free component (post-tax contributions) and taxable component (pre-tax contributions and net earnings). These components at the commencement of a pension are converted into a percentage and from that point forward (for the life of the income stream) remain in accordance with the proportions in which it was established, regardless of the change in the value of the member’s benefit.
To explain this, let’s look at an example in detail…
Jack is 60 years of age at 30 June 2007 and contributes $1 million into an SMSF, which was up to the non-concessional contribution cap at that time. From 1 July 2007, Jack commences an Account Based Pension with this amount, which he withdraws a tax-free minimum pension (4%). This pension is purchased as 100% tax-free component as it was the only money held by the member within the fund.
Assuming an net earnings rate of 8% (in pension phase) and that Jack withdraws a minimum pension each year, it is projected he will have the following account balances after:
- 5 years of $1,216,653
- 10 years of $1,410,434
- 15 years of $1,635,080
As a result of the pension starting with 100% TF component, the growth in the account balance is attributed to the tax-free component. This is particularly important for estate planning purposes, as any non-dependent beneficiaries ultimately entitled to these amounts will receive the remaining balance without incurring any tax. A very good outcome…
However, if we take the same set of circumstances and apply the ‘old’ rules to Jack’s position that existed up to 30 June 2007, you will see a drastically different result to the components and ultimately for the beneficiaries of his estate.
Applying the old allocated pension rules to this $1 million pension purchase, Jack has an annual deductible amount each year of $46,168, which is calculated as the Undeducted contributions (or now tax-free component divided by the life expectancy at commencement, which was 21.66 years). This amount each year then reduces the Undeducted contribution (“UDC”) balance. Applying the minimum pension amount that needed to be withdrawn, plus the same 8% net earnings rate, the following projected account balances are:
- after 5 years $1,136,351 (UDC reduced to $769,160)
- after 10 years $1,248,078 (UDC reduced to $538,319)
- after 15 years $1,307,402 (UDC reduced to $307,479)
The first point to note is that the old allocated pension factors did require a greater level of minimum pension drawdown than the current minimum % rules. This explains the variance in the account balances after the same period of time.
However, in looking at the break-up of components, under the old rules, the (now) tax-free component has reduced to $307,479 after 15 years. This is against a tax-free balance in the current rules of 100% of the account balance. This equates to a $1,327,601 difference in tax-free component.
When talking about this in estate planning terms, it means that the tax saving to Jack’s beneficiaries (non-dependent) will be between $199,140 (15%) and $219,054 (16.5%, includes medicare levy), subject to whether the money was paid to the estate or directly to the beneficiaries. Correct me if I’m wrong, but this is a fairly sizeable tax saving??? As I stated earlier, I’m not sure who in Treasury let this get through, but applied appropriately, the federal government stands to lose hundreds of millions of dollars where people can structure (and re-structure) their affairs to maximise the tax-free proportion of an income stream.
What about under 60?
The benefits also exist from somebody under the age of 60, as should they be drawing a pension (or transition to retirement income stream), it is assessable and must be declared within their personal tax return. However, any tax-free component does not need to be declared, therefore in Jack’s case, if he was under 60, he is effectively drawing a tax-free income stream now without having to rely on the rules from age 60 (where the pension simply becomes non-assessable).
Running a multiple income stream strategy within an SMSF is one of the most powerful strategies available, in particular where you are dealing with high net worth individuals who are likely to have substantial balances inside superannuation.
A simple recontribution strategy, subject to a cashing condition having been met, can effectively allow someone between 60 – 64, to withdraw $450,000 tax-free and recontribute this back into super using the ‘bring forward’ rules. Structured appropriately, a separate interest is created and a 100% tax free proportion is locked in on this money for the remainder of the pensioner’s life (and any dependent beneficiary). To take the strategy further, consideration can then be given to setting up a segregated investment strategy for the 100% TF pension to maximise the capital growth of this segment of the member’s super to minimise the long term tax impost expected when there are no longer any dependent beneficiaries.
I’ve attached below a summary of my basic workings of Jack’s example to demonstrate what I believe to be the biggest change introduced in the Simpler Super reforms.