It’s a tax haven
Most of us regular working folk look at how much tax we pay each year and wonder – “Seriously?” For Australians, it’s sort of the negative yin to the positive yang of our love for property. Looking at a payslip, it can be hard to imagine why a government needs all that money.
As Kerry Packer once said in a tirade to a government committee:
“As a government, I can tell you you’re not spending it that well that we should be donating extra”.
The uber-rich like offshore tax havens.
But normal Aussies have an onshore tax haven to help minimise tax that’s nearly as good. It is, in effect, a legal tax dodge.
It’s called superannuation.
And you need to understand how you can use it to pay less tax. Or don’t. But you won’t get a Freddo Frog from the tax office.
LOW TAX, NO TAX
Governments tax super, but generally far less than they would tax you personally.
And that’s only while you’re working. When you’ve retired, they generally don’t tax super at all.
First, let’s understand contributions.
If you contribute money to super – either via salary sacrifice or personal deductible contributions
– you only pay tax at the super tax rate of 15 per cent.
Let’s take someone earning
$90,000. On that last
$10,000 of income, they pay 34.5 per cent tax, so pocket $6550.
If they put it into super instead, it only gets taxed at 15 per cent, meaning $8500 is what their super fund has to invest.
BUT WAIT … THERE’S MORE
That’s an extra $1950. A fair chunk of coin. Imagine if you did that every year for 15 or 20 years? That’s a lot of tax you haven’t paid. (The downside is you can’t touch it just yet.)
The next part of super’s benefit is that whatever it earns through its investments, is also only taxed at 15 per cent (or less).
And on this goes – year after year. That’s called compounding. When most people think of compounding, they think of how an investment grows on itself each year. And that’s correct.
But there’s a forgotten sibling. Lower tax rates are also a powerful form of compounding. If you get to keep more each year by paying less tax, then that’s more to reinvest.
Let that thought settle for a bit.
GETTING MONEY IN
There are three main ways to get money into super tax effectively – but only two involve a choice.
The first one is the 10 per cent superannuation guarantee your employer makes for you. No choice.
The other two are salary sacrifice and personal deductible contributions. They differ in how you put it into super, but from a tax point of view they end up identical.
Salary sacrifice is done through your employer. It’s an agreement with the taxman to forgo some salary to put into super.
Taken as income, the average worker would only receive $655 of their last $1000 in salary (34.5 per cent tax). However, their super fund will end up with a net $850 (15 per cent tax).
Personal deductible contributions are when you put money directly into super yourself (generally by bank transfer) and then claim a tax deduction for doing so.
So, by contributing $1000, you got $345 back – a net contribution of $655. But your super fund keeps $850.
The overall tax impact is identical. There are two other main things to consider here.
The combined limit on these three contributions is $27,500 a year. And if the maths scare you … get advice.
BAKING THE CAKE
What we’re essentially looking at is a bunch of ingredients. Let’s combine them now and shove them in the oven.
Here are the assumptions. Take someone earning $60,000 to
$120,000, who has spare money at the end of the year to invest for the long term – for retirement.
The choice is to invest inside or outside super. They can pick the same investment either way. Any tax that will be paid will be from the investment.
They’re going to do the equivalent of $10,000 before tax. So, that means in his personal name they could tip $6550 into the bowl, while their super fund would get $8500 in its bowl to invest.
Turn the oven temperature (investment returns) to 7.5 per cent before tax. Now cook for 20 years. What do you get?
The personal investment is worth about $19,300.
The super investment is worth about $30,300.
Who’s going to argue with having 57 per cent more cash at the end of 20 years for effectively the same pre-tax starting amount?
If you take away the different starting investment amounts, what you’re doing is comparing different after-tax investment returns.
Here’s another stat from these numbers.
How long does it take for both pots to get back to $10,000? The non-super investment ($6550) takes nearly eight years to get back to $10,000. Super ($8500) takes a little over 2.5 years.
NOT JUST ONE CAKE
But, see, we’re only talking about $10,000 in a single year.
This is where super becomes really powerful, because you’ve potentially got a working life to do this.
Every. Single. Year.
If you start doing this at age 45 and just did it for 10 years until age 55, you would end up with an investment of $153,300 outside super, or $231,400 inside super.
For the whole 20 years until
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Learning how to get the big gest or b est super cake can be great fun. R eading, then baking, those rules to your situation c an be rewarding.
retiring at age 65, it would be $242,000 versus $354,000.
“BIGGER” BAKERS?
With the above, we’ve used someone on the middle marginal tax rate of 34.5 per cent.
The strategy will work even better for those earning in the next tax bracket of 39 per cent.
And that’s because they would lose more of the initial $10,000 in tax before they start baking.
So, what about those on the highest marginal tax rate of 47 per cent? Well, yes, it would be even better, but …
The problem for those on the top marginal tax rate is that they have a few extra restrictions put on them.
Firstly, if their salary package is more than $250,000, they pay extra tax on some or all of their super contributions. Instead of being taxed at 15 per cent on the way in, it gets taxed at 30 per cent. (This is known as a Division 293 tax bill.)
A second obstacle is that they will struggle to put more tax-effective money into super if they are employees.
Take an employee earning $200,000 a year. Their employer already puts $20,000 into super for them.
With a total limit of $27,500, they can only contribute an extra $7500.
It’s still generally going to be worth it for them, because the ongoing tax on earnings in super is still a maximum of 15 per cent. They might as well have that money sitting in super paying less tax.
“SMALLER” BAKERS?
The strategy doesn’t work as well for those on lower incomes. But don’t misread that! That is NOT to say that super is no good for lower-income earners.
If your income is below $45,000, your maximum tax rate is 21 per cent, so it’s not much more than the 15 per cent inside super. Incomes below $18,200 don’t pay tax.
Governments give other super incentives to help here, such as refunding the 15 per cent super tax for those h earning i g less than th $37,000 and offering a co-contribution of up to 50 per cent for contributions of up to $1000 for those earning less than $56,112.
BAKE OR BUY?
Learning how to get the biggest or best super cake can be great fun. Reading, then baking, those rules to your situation can be rewarding.
But if you’re not prepared to do the baking, then you should still buy the cake. And by that I mean get advice. Financial advisers bake these cakes for breakfast.