I am a 57 yr old part time female worker working 2 days a week as a nurse. My hubby is a process worker working 38hrs week and has a second job delivering Pizza. My 3 children stay as at home with the eldest working full time this year and the twins still in 3rd year uni. We have a total loan of $500,000 for an investment property unit in Fairy Meadows (near Wollongong NSW) for $250,000 with ANZ Bank and LOC with ING Bank for $250,000 with our house as security for investment in shares and property stgelopment. I am behind in superannuation with SASS in the old defined benefit scheme with pension option which cannot be converted into the new TRAP or any other schemes. Should I put any excess money into my new superannuation FSS which I started with $10,000 last year or should I pay into reducing debt as they are tax deductible?
Making a decision on allocation of your precious income is always a hard one – be it expenditure for lifestyle, paying for children’s education, reducing your mortgage, saving for retirement…the list goes on. Then there are the endless investment choices – cash, shares, property, managed investments, CFDs…
The bad news is that there is no one answer that suits everybody. “Should I do A or B” comes down to your goals at the time, legislation at the time and your age when making the decision. This is why it is so important to regularly come back to your plan and review whether what you have in place makes sense.
The good news is that there are some general principles to go by based purely on the numbers.
Many people have moved into lower marginal tax rates with the changes in personal tax scales over the recent years. This means that tax minimisation strategies (including negative gearing) have become less effective. Where you may have been getting 40 cents in the dollar back before, now you are only getting 30 cents. And 10 cents less tax return on the interest cost of $500,000 borrowed can hurt, because it means YOU have to put the money in to sustain the investment rather than the taxman!
As a starting point, paying off debt which is tax deductible is not tax effective. Firstly, in order to repay the bank, you have to receive money in the hand which has already been taxed at your marginal rate – say 31.5%. Then you are reducing your future tax deductibility because you will pay less interest next year. So reducing your interest cost may be better for next year’s cashflow but it’s not great tax planning.
The other thing to consider is that reducing debt improves your equity in the investment, but it will not make your investment go up in value any faster. That is, you can’t improve the quality of your investment by reducing debt (the old purse out a pig’s ear trick!).
We’ve compared salary sacrificing into super with a strategy of borrowing to fund non-super investments at various tax rates. Remember that this type of analysis relies on tonnes of assumptions (shown below) so keep that in mind.
The gearing option will provide a better result than the non-gearing option. But when compared to superannuation salary sacrifice, the super alternative produces marginally superior results over all periods. This has a lot to do with the fact that Capital Gains Tax is payable when you exit the non-super investment, but the withdrawals from super after age 60 are completely tax free.
If you are in the 31.5% tax bracket, then the super result can be enhanced through the Government co-contribution scheme where your $1 after tax contribution into superannuation is matched by $1.50 from the government. That’s a guaranteed 150% return!
You should also note that the salary sacrifice option does not have the increased risks of borrowing associated with gearing strategies. The table below shows how sensitive your total nest egg is to rising interest rates when borrowing is used versus superannuation (assuming 46.5% personal tax rate):
To be fair, the benefits arising from salary sacrifice contributions will be subject to preservation. You cannot generally withdraw funds from super as a lump sum until retirement on or after preservation age (55 but phasing to age 60 for those born after June 1960). You can commence a non-commutable income stream under the transition to retirement rules on or after reaching preservation age – but only if your scheme allows it.
There are no specific tax or superannuation laws, which prevent you from salary sacrificing 100% of your salary. However, there may be restrictions imposed in awards or industrial agreements – so you must check these first by speaking with your employer. Not to mention the cashflow aspects of salary sacrificing 100% of your income – you may still want to eat!
Further, care must be taken to ensure that you do not exceed your concessional contributions cap by undertaking a salary sacrifice strategy. Your cap is made up of total of all employer contributions (including salary sacrifice and superannuation guarantee) and any personal deductible contributions for the financial year. The cap is $50,000 (indexed) per financial year for individuals under age 50. A transitional cap of $100,000 per financial year (unindexed) applies to individuals who are age 50 or over at any time during a financial year during the transitional period (up until 30 June 2012).
So, from the sensitivity analysis we conducted, it could be surmised that:
* The gearing strategy performs relatively better, notwithstanding the increased risks associated with the gearing strategy, under lower interest rates, higher investment income and lower Marginal Tax Rates (MTRs).
* The superannuation salary sacrifice provides better results in the event of higher interest rates and higher MTRs.
* In a post 30 June 2007 environment where withdrawals from super are tax free after age 60, salary sacrifice to super contributions have enhanced their relative attractiveness versus borrowing to invest.
* The investment in either alternative is a share-based unit trust with a gross income return of 3.0% (70% franked) and capital growth of 5.5%
* Gross interest expense is 8% pa
* Super benefits are taken after age 60 as a lump sum tax free
* All net of tax income distributions are reinvested to purchase additional units in the share trust.
* At the end of the period, all share trust units are sold, Capital Gains Tax (CGT) is paid, based on the same marginal tax rate, and loans repaid. The balances are then compared with the after tax results they would have achieved via the superannuation salary sacrifice alternative.
Jeremy Gillman-Wells is an Authorised Representatives of AMP Financial Planning Pty Limited | ABN 89 051 208 327 | AFS Licence No 232706.
Disclaimer: This article is general in nature and is not intended as investment advice. Readers should always seek further advice before making any financial decisions.