The Prime Minister’s broken promise on tax cuts has prompted speculation about other possible tax promises that the government may be considering breaking. A perennial topic in that space is the belief that super is very lightly taxed and is therefore a prime candidate for special attention. This is because super in the accumulation stage is only taxed at 15 per cent and investment earnings inside super funds in retirement are tax free. Moreover, withdrawals by members from those funds in retirement are also tax free.
How it works elsewhere
In most countries, contributions to a retirement fund are not taxed and the income earned by those invested contributions within the fund are also not taxed, but retirement benefits paid to members are then taxed as normal income at marginal rates in which high income earners pay a higher proportion of that income in taxes. This approach has two advantages:
- The nest egg can accumulate to a larger amount, thanks to the benefits of compounding as there are no withdrawals from the fund over a working lifetime, and larger nest eggs generate more tax.
- Retirees face the same tax rates as other taxpayers and so there is no intergenerational envy over any special treatment they receive.
It is important to remember that super is a long-term project with contributions over a working life that can extend over 40 years and a retirement that can extend over 30 years. That means we need to take account of the cumulative effects of investment decisions.
Australia is different
In Australia, we do things differently and those cumulative effects make a substantial difference. Firstly, in Australia, all super contributions to super are taxed before being invested.
- Employer contributions (SG and salary sacrifice) are paid into the fund as pre-tax contributions, because neither the employer or employee pays tax on them. These are called concessional contributions because a tax concession is claimed on them. They are then taxed within the super fund at 15 per cent before they are invested. Therefore, of a pre-tax contribution of $10,000, only $8500 is invested.
- Personal (after-tax) contributions, such as the sale of an investment or an inheritance are called non-concessional contributions because no tax concession has been claimed on them. They have been taxed at the personal marginal tax rate before they arrive in the super fund. As these are already taxed, no further tax is paid by the fund.
Secondly, all the earnings from the combined invested contributions are taxed within the super fund every year at 15 per cent. Since no super withdrawals by members are permitted before retirement, these investment earnings are reinvested and subject to compounding.
The effect of this tax on earnings is to reduce the amount reinvested and that effect is also cumulative. Whatever the fund can earn on its investments, only 85 per cent of it can be reinvested after the 15 per cent tax (ignoring fees). If, for example, a super fund can earn 8 per cent on its investments, only 6.8 per cent is reinvested each year.
To illustrate this, imagine a non-concessional super contribution of $10,000. If this was treated the same as a contribution to a retirement fund as in other countries, and we assumed an investment return of 8 per cent for 40 years, this would compound to $201,153. A sizeable nest egg.
Now let’s assume that this was a salary sacrifice concessional contribution. It would be taxed as a contribution at 15 per cent in the fund prior to investment so that only $8500 was invested for 40 years. When this is compounded at 8 per cent over 40 years, the result is lower because it compounds from a smaller amount. It is now $170,980.
If we account for the cumulative effect of the 15 per cent tax on investment earnings, the compound rate over 40 years is only 6.8 per cent, not 8 per cent on an initial investment of only $8500, not $10,000. The retirement balance is then $110,585. That differential is entirely due to the combined effect of these taxes.
Clearly the result of such a projection is highly sensitive to the compound earning rate selected and the length of time for that compounding to take effect, but the result of these two super taxes (on entry and on earnings) is more substantial than a ‘concessional’ tax of 15 per cent would suggest.
Instead of claiming that super benefits in retirement are tax free, it would be more honest to describe these retirement benefits as tax paid.
It is the fact that super is tax paid that creates complications. For example, if there is money remaining in a super fund on death, there is an additional tax on the death benefit. That tax amount depends on the beneficiary. A spouse and dependent children can collect it tax free but adult children pay an additional death tax. More importantly the tax payable depends on the proportion, not the amount, of non-concessional contributions within the fund because that part of the death benefit is regarded as a return of the contributor’s own money. Because it has already been taxed as a contribution, it is therefore tax free as a death benefit. By contrast, the concessional component has only ever been concessionally taxed and is therefore subject to this death tax.
More tax, please
One might ask why, when designing this super system in 1993, Treasurer Paul Keating adopted this complicated hybrid system compared to other simpler retirement savings systems around the world. The answer is simple. He was not prepared to wait 40 years before the government collected any tax from these retirement savings. The legacy of that decision, however, is that we now have a super system that causes much confusion and intergenerational envy.
This article appeared on FirstLinks and is republished with permission.
Would you support a change to the way super is taxed in many other countries? Share your thoughts in the comments section below.
Jon Kalkman is a former director of the Australian Investors Association. This article is for general information purposes only and does not consider the circumstances of any investor. This article is based on an understanding of the rules at the time of writing and anyone considering changing their circumstances should consult a financial adviser.