The $3 million conundrum

The proposed Division 296 tax has already prompted discussions as to the merit of continuing to make investments in the super system. Heffron managing director Meg Heffron uses some simple modelling to determine if taxpayers should consider building wealth outside of super should the new tax be implemented.

While the legislation hasn’t yet been passed (and is in fact stuck in a Senate committee until 10 May), the proposed new tax on members with high super balances has certainly created a storm of interest in the SMSF world.

The key question posed by many clients who already have very large balances is: “Will this tax be so bad that I should take my money (or at least the balance over $3 million) out of super?”

And the answer is, as usual, it depends. But there are definitely some observations we can make. To make them, I modelled the following client scenario.

It involves a 65-year-old client who initially has $7 million in an SMSF. There are no other members of the fund. The client has a retirementphase pension worth $2 million and the remainder is in accumulation phase. Minimum pension payments are drawn each year.

Their primary concern is whether or not to withdraw $4 million from their fund to reduce their balance to $3 million, largely avoiding the proposed new tax.

I have assumed the tax, now known as Division 296 tax, works exactly as outlined in the legislation currently before parliament.

I also assumed:

• investment returns will be the same regardless of whether investments are made within super or outside super with the only difference being the tax environment,

• a key factor influencing the calculations is how the investment return is made up between capital growth and income. I assumed 5 per cent income (including the impact of franking credits) and 3 per cent capital growth (but then varied this as outlined below),

• inflation is assumed to be 3 per cent a year and all amounts projected into the future are adjusted for inflation. This means dollar amounts are directly comparable to these amounts today,

• amounts drawn as pension payments will be the same regardless of the scenario, and

• a key difference between leaving the full $7 million in superannuation versus withdrawing $4 million is that under the remove from super option, earnings and eventual capital gains on the non-superannuation assets will be taxed at non-super rates. To this end it has been assumed:

o a tax rate of 30 per cent (plus the 2 per cent Medicare levy) will apply for most people most of the time on income outside super, or the highest marginal tax rate of 45 per cent plus Medicare will apply for very high rates of income (for example, when capital gains are realised). Given recent modifications to the stage 3 tax cuts, this assumption is perhaps a little conservative (that is, in fact, more tax will be paid outside super than assumed). But importantly, I have assumed wealthy individuals have some means of reducing their income below the top marginal rate most of the time,

o members with non-superannuation savings will have some income already, enough to place them in the 30 per cent tax bracket. In other words, the modelling very deliberately assumes it is not possible to remove wealth from super and have it invested while attracting less than 30 per cent tax. Individuals who could do that are assumed to have done it already,

o they will have the flexibility to arrange structures that optimise tax outcomes, including a family trust with the possibility of a corporate beneficiary, and

o the outcome is that income will be taxed at a maximum of 30 per cent and capital gains, when realised, will be eligible for a 50 per cent discount but taxed at 45 per cent plus Medicare. This is imperfect in that it doesn’t contemplate additional applicable taxes if the income was distributed to a company and then later to individuals. Effectively it assumes there will be enough individuals around to receive the income or that by the time money is paid out of a corporate beneficiary, the recipients can receive this at no more than a 30 per cent tax rate. This definitely paints the removing from super option in an unduly favourable light, but it will do for now.

The first scenario

Initially, I assumed the member could withdraw $4 million from super without paying any capital gains tax in the super fund at all. It’s as if the fund had recently sold an asset and had the cash available to reinvest – the only question was whether this should be in super or externally.

I also assumed in either case the new asset was purchased now and then sold after six years.

The exact timing isn’t critical, but assuming it is sold at some point is important. That’s because one of the most significant features of the Division 296 tax is it brings forward the taxation of capital gains, in effect making super an unattractive place to build up those gains. But eventually, when the asset is sold, super is actually a far more attractive place to pay tax on realised gains. So we can’t make a fair comparison unless we assume the asset is sold at some point.

I then projected two scenarios into the future:

• option 1: the entire $7 million remained in superannuation incurring Division 296 tax, versus

• option 2: $4 million is invested outside superannuation with minimal amounts of new tax applying.

What the modelling shows

Graph 1 shows the difference between the two situations.

If the graph is above $0 at a particular time, option 2 is better at that time.

In contrast, if the graph is below $0, option 1 is better at that time. All figures are adjusted for inflation so are directly comparable to amounts today.

Initially, while the $4 million asset is growing in value, the member is better off if it is held outside superannuation. That’s because the tax on the income component is broadly the same under both options (in fact, marginally favouring keeping the $4 million inside super as explained in section 3) but the treatment of the growth is different. Under option 1, Division 296 tax will mean taxes are paid on the growth as it occurs. No equivalent tax applies under option 2.

But this phenomenon reverses when the asset is sold. At that point, growth over the past five years is taxed all at once under option 2. And it is assumed to be taxed at quite high rates, that is, 45 per cent plus Medicare, after allowing for the normal 50 per cent discount landing at an effective tax rate of 23.5 per cent.

In contrast, realising the asset has no impact at all on Division 296 tax (remember under this tax, a proportion of the gain is taxed progressively as it emerges, not when it’s realised) and so the usual superannuation tax rates apply. At worst this is an effective rate of 10 per cent on the capital gain.

In fact, in this fund, the effective tax rate will be less than 10 per cent because the member has a pension account. By the time the asset is sold, the pension account is projected to represent around 25 per cent of the fund, meaning 25 per cent of the capital gain is exempt current pension income (ECPI) and so entirely exempt from tax.

It is easy to miss this last point as conceptually we typically view the extra $4 million as an amount over and above the fund’s pension account. So in theory, the existence of ECPI should be irrelevant as it only relates to the pension part of the fund.

But remember the ECPI portion is applied to every $1 of income in the fund. In this case we are modelling the impact of simply selling one asset, the one with a value of $4 million purchased at the start. Even though this is notionally the money over and above $3 million and so definitely over the pension account, it still shares in ECPI.

The net result is that once the taxes triggered by selling the asset have been taken into account, the member is actually slightly better off if the entire balance has been left in superannuation from the start. And interestingly, even when option 2 appears more favourable, that is, while the asset is still growing, the difference is modest in relative terms (the graph peaks at $50,000 in today’s dollars, compared to a total wealth at the start of $7 million).

Variations

Not surprisingly, this modelling was repeated on a great many different scenarios to see what could potentially change the outcome. My broad conclusions from those extra calculations could be summarised as:

• changing the return mix between income and growth, that is, assuming more of the income came in the form of capital growth and less as income, did change the picture. Not surprisingly that scenario favored option 2. But not enormously and the big reversal in benefits at the time of sale was still very evident,

• assuming the asset was held for longer than six years didn’t change the overall outcome of a roughly neutral result once the asset was eventually sold, and

• allowing for even very small amounts of capital gains tax upfront, that is, if it was necessary to realise gains in order to transfer cash or assets out of super, made it far more attractive to leave the asset in super.

There are, of course, many other scenarios we could model and I will definitely continue to do so.

A final point for context

In all of this modelling, the overall result was actually that the two options gave the member a very similar outcome. In other words, for someone with these particular circumstances, the significant tax benefits of super have been eroded so much that it’s no longer critical to maximise exposure to super at all times. Of course, it’s still very tax advantaged up to $3 million, but the decision is less important for the $4 million over and above that amount.

That makes it far easier for clients to prioritise other things in later life. In the future, for example, will we see clients withdrawing money from super earlier simply because they want to:

• reduce the risk of high death benefit taxes,

• make their estate planning easier by having more of their assets in a structure that can be better controlled by their will, and

• buy assets in an environment where they won’t be forced into realising capital gains at some point (remembering that death is one circumstance where money has to be taken out of super).

I think we will. And we’ll start to see a greater focus on gradually drawing down larger balances over time rather than leaving as much wealth as possible in super. And that’s not such a bad thing.