A common investment strategy aimed at reducing tax is to withdraw money from an SMSF then contribute it back into a tax-exempt segment of the same fund.
This strategy was particularly common before July 1, 2007 when changes made it impossible to selectively withdraw the taxable components of a super fund. However, the recontributions strategy is still useful for those who are able to take a pension under 60 years of age. For those over the age of 60, pension withdrawals are tax-free.
Meet Tom, age 56
Let’s look at an example. Suppose Tom Smith, age 56, is fully retired and has $1.5 million in super assets. Let’s assume this entire amount is a ‘taxable component’. (In general terms, all super benefits are split between tax-free and taxable components. Super fund trustees have to calculate these components for each benefit that is paid. For more on this, please read our segment on How your SMSF is taxed.)
Tom’s pension would be $60,000 a year based on a minimum payment of 4% per annum (see Paying Pensions). Assuming Tom has no other income, this pension would be taxed $3,147, which is arrived at by taking income tax (including Medicare Levy and Low Income Tax Offset) of $12,147 and subtracting a 15% rebate of $9,000.
Tom could reduce his tax by using the re-contribution strategy. Under current tax rules, you can take $185,000 of the taxable component out of your SMSF as a tax-free lump sum as long as it is done before you turn 60 years old. This figure is called the ‘low rate cap’ and it is indexed each July 1. The figure shown applies in the 2014/15 financial year.
Assume Tom withdraws $185,000, or 12.33% of his fund’s value from his SMSF and a short time later contributes it back into his fund. He still has $1.5 million in assets but 12.33% of his SMSF is now a tax-free component while 87.67% is a taxable component.
If he now took an Account Based Pension of $60,000, only the taxable component (87.67%) or $52,602 would be subject to tax. Net tax of $1,594 would be payable, which is arrived at by taking income tax (including Medicare Levy and Low Income Tax Offset) of $9,484 and subtracting a 15% rebate of $7,890. This represents a saving of $1,553 ($3,147 – $1,594). Over the next four financial years Tom will save $6,213 in tax.
Some warnings: For this strategy to work, it is essential to make sure that any contribution put into super is not subject to excess contributions tax. In this case, Tom will take advantage of the ‘bring forward rule’, which allows him to make up to 3 years’ worth of non-concessional contributions in one year. Also, if your super fund has to sell assets to pay you the benefit, make sure you factor in any capital gains tax payable by the super fund into your assessment of the strategy. Also make sure you factor into your costs any additional super fund administration costs or advice costs.
Recontribution tax savings on death benefits
There is another reason to withdraw a lump sum and recontribute it back into super and that’s to reduce the amount of tax potentially payable on death.
Any taxable component of a super fund death benefit paid to ‘non-dependants’ (which is defined by the ATO to include adult children) will be taxed at 17.0%. (Note: non-dependants may only be paid a lump sum death benefit – a pension cannot be paid). Therefore moving money from the taxable component to a tax-free component can have a very significant impact.
If we take the example of Tom above, we see that he now has 12.33% of his benefit as a tax-free component. Once his pension starts, this percentage is locked in and doesn’t change. Suppose that when he dies his pension’s account balance is worth $1.2 million. This means his tax-free component is $147,960. The effective tax saving when the lump sum is paid to the non-dependant is $25,153.
The ideal time to initiate the withdrawal and recontribution transactions (in connection with death benefits to non-dependants) is when withdrawals from super are tax-free. That is, after age 60.
Some warnings: It’s important to consider your ability to make super contributions while avoiding the excess contributions tax. Make sure that if your SMSF has to sell assets to make a benefit payment that you factor in capital gains tax.
- The withdrawal and re-contribution strategy delivers potential tax benefits for retirees under age 60 and provides tax benefits for non-dependant death benefits.
- Before you embark on this strategy, make sure you check all its costs such as CGT, advice and administration fees.