Plan B if the Federal budget cuts superannuation contribution caps
Written and accurate as at: Apr 18, 2016 Current Stats & Facts
By Kate Cowling, Personal Finance Reporter for the Australian Financial Review, written 9 April 2016
Investors faced with the prospect of being able to put less into superannuation are already looking for other ways to boost their retirement savings. While it won't be clear until budget night on May 3 whether pre-tax super contribution caps will be lowered, financial advisers say if this does happen, there are other (albeit not as tax-effective) strategies to add to retirement nest eggs.
Super has long been one of the best ways to put money away for the future while saving on tax, which is likely to be one of the reasons it's still on the government's radar.
While a reduction of the pre-tax super caps to $20,000 a year (regardless of age) has not been confirmed, it is one of the few levers the government has to pull that has not been ruled out. Current levels are $30,000 for people 49 and under, and $35,000 a year for those 50 and over.
When changes like this are on the table, advisers say investors jump on the offensive and look for other tax-effective ways they can increase their retirement savings.
This isn't always easy, says Nerida Cole, head of Dixon Advisory's financial advice arm. She warns there are a number of complications attached to saving outside of super – ranging from fees and administration to confusing terminology.
Then there are options such as high-risk agricultural schemes that should be avoided at all costs, says David Simon, principal adviser at Integral Private Wealth.
Nonetheless, there are some existing strategies, like insurance bonds and family trusts, that may experience a resurgence if caps are reduced and savers look for other ways to insulate wealth.
We asked the experts for a reminder of how these strategies work, who they are appropriate for and what dangers they carry.
INSURANCE BONDS (IF YOU ARE IN THE TOP TAX BRACKET)
Insurance bonds (also called investment bonds) are one of the wealth-building strategies that has fallen by the wayside, says Simon.
But others like adviser Suzanne Haddan, managing director of BFG Financial Services, says she uses them for her clients regularly to complement other savings strategies such as salary-sacrificing into super.
Primarily sold through life insurance companies and building societies, they are essentially a life insurance policy with the features of a managed fund (in that you can choose the asset allocation).
All earnings within the structure attract the corporate tax rate of 30 per cent, which can appeal to investors on higher marginal tax rates.
But after 10 years no further tax is payable, says Simon. As he illustrates in the accompanying case study, an investor would be $12,500 better off using this structure rather than investing in his or her own name.
See case study http://www.afr.com/personal-finance/saviour-strategies-if-the-budget-targets-super-caps-20160330-gnuohb#ixzz46A6pJfDv)
Investors can top of up the amount in the fund as long as one important rule is followed. If their subsequent investment exceeds 125 per cent of the initial investment, they trigger something called the "125 per cent rule", which sets back the 10-year benefit to year one for the newly invested amount.
Given the 10-year tax benefit, they are most suitable for investors with longer time horizons. The risk level varies depending on the underlying investments. For example, someone wanting to mirror a growth portfolio in their super fund could have the same underlying investments in their insurance bond. Someone wanting a more defensive strategy would choose this investment option in their insurance bond.
If super caps are reduced, says Haddan, insurance bonds could be one of the options future retirees turn to if they've paid off their mortgage and other debts.
INSTALMENT WARRANTS (IF YOU HAVE 20 YEARS+ TILL RETIREMENT)
For investors further from retirement who can afford to take on a more aggressive strategy, Simon says instalment warrants may receive further interest as an alternative to salary sacrifice if caps are reduced.
An instalment warrant is a bit like a lay by on an asset like shares, he says.
The easiest way to think of it is you're putting down a deposit, or a part-payment, and re-paying the remaining amount on the listed asset in instalments over time.
A key selling point is the fact you get all the benefits of owning shares, such as dividends and franking credits from day one, Simon adds.
As a form of leverage, the interest component of the loan and the borrowing fee can be offset against tax.
"The interest can be prepaid over the life of the warrant, which can give them quite a rich tax benefit," Simon adds.
There are also self-funding instalment warrants available to people with self-managed superannuation funds (SMSFs), which use dividends from the shares held to pay off the loan.
"Given members may be further restricted to boost their superannuation balances due to potentially reduced caps, this may be an alternative strategy to gain greater investment exposure and offset some of the reduced capacity to invest," says Simon.
But instalment warrants carry several warnings, including the risk of legislative change and the risk of interest rate rises.
Gearing magnifies losses as well as gains. If the share price of the underlying asset falls, the value of the instalment warrant may fall at a quicker pace, says Simon.
The loan amount can also increase if the interest that capitalises to the loan is higher than the dividends or distributions from the share.
Given it's a fairly aggressive strategy, it is best suited to people who have a longer investment horizon so they can ride out the volatility.
"You have to ask yourself is the risk worthwhile," says Justin Hooper, an adviser at Sentinel Wealth.
"Do you need that level of return to justify the borrowing? Can you handle the risk? If the answer to the first two questions is yes, then it may be fine."
See case study http://www.afr.com/personal-finance/saviour-strategies-if-the-budget-targets-super-caps-20160330-gnuohb#ixzz46A6pJfDv)
FAMILY TRUSTS (IF YOU HAVE YOUNG ADULT KIDS OR A LARGE INVESTMENT PORTFOLIO)
The attractiveness of super as a savings vehicle and repeated tax office scare campaigns has meant family trusts get far less publicity than they once did. But if used correctly, they can still be an effective way to add to your nest egg.
Financial and tax advisers expect changes to super caps could prompt investors to re-look at trusts. These allow higher-earning family members to distribute income to lower-earning family members to even out the tax burden among the family.
"A family trust gives you the opportunity to distribute income to taxpayers who don't have very high taxable income and protect your assets for future as well as current generations," says Hooper.
If you have children aged 18 to 23 who are studying, a family trust can work well because you can apportion income to them to lower your own tax burden and they can learn about money at the same time, he adds.
Say your daughter is a uni student and you are paying her an allowance of $50,000 a year from your investment income, while you are on the top tax bracket of $180,000. Rather than paying these out of your own after-tax money, the family trust would make the distribution to her and she would then pay her own expenses. She would pay $7800 in tax, but in a trust setting would save you $10,700 in tax by reducing your liability.
The strategy works similarly if one partner is on a lower tax bracket.
You won't be able to use the strategy for children under 18 though, as investment income above $417 is taxed at a higher rate, which makes the tax benefit negligible (66 per cent between $417 and $1307, then 47 per cent not including the Medicare levy).
Family trusts are accessible before retirement and can also be used to safeguard assets for designated people and purposes, which can prevent them falling into the wrong hands in the case of death or divorce.
But with annual running costs of around $2000 and set-up costs of about $2000, they are only appropriate for people with the ability to build up $200,000 or more within a five-year period, says Jonathan Philpot, wealth management partner at HLB Mann Judd.
Philpot says when the trustee approaches retirement, they can shift a large chunk of their family trust holdings to super via after-tax contributions to offset capital gains.
It works something like this: say you have $1 million in the family trust at 60 when you retire. You can still contribute to your super fund until you are 65, so you move $200,000 each year between 60 and 65 from the family trust to the super fund. Whatever capital gains you are realising in the family trust, says Philpot, you are then able to offset with super deductions in your own name.
"With a self-managed super fund, you can do that by transferring your share portfolio from the family trust to the super fund – you don't have to sell your shares," he adds.
The information featured here is general in nature and does not take into account your objectives, financial situation or needs. You should consider the appropriateness of the information to your own circumstances. Before making an investment, insurance or financial planning decision, you should consult a licensed professional who can advise you of whether your decision is appropriate.