Clever DIY super strategy – but is it legal with the ATO?

Question:

I have a large taxable component in my self-managed super fund. My financial advisor suggests I withdraw $140,000 and deposit it into my own bank account for one day then deposit it back into the SMSF and repeat this transaction for the next five years. Is this legal with the ATO?

Answer:

Super re-contribution strategies have been used for tax minimisation in conjunction with retirement planning for years. The interesting thing is that as superannuation legislation has changed, the reason why we undertake recontribution strategies has also changed.

Now like all technical strategies, this answer relies on a few assumptions. So, in order to answer the question we will assume that you are aged between 55 and 60; your superannuation fund is unable to make an anti-detriment payment (refund of tax paid in the event of death); and that there are two components to your superannuation:

– Tax-free component – generally representing the personal contributions you have paid into your super fund from after-tax money. These are tax-free in the event of death no matter who they are paid to.

– Taxable component – generally representing the contributions that your employer has paid into your super fund as superannuation guarantee or salary sacrifice contributions. Alternatively, it could be those contributions that you have made personally and claimed a tax deduction. Without getting into the complicated arrangements in the event of death; let’s just say that the taxable portion of your super fund is tax-free if paid to a financial dependant when you die, however in the event that it is paid to a non-dependant, this portion will be taxed at 16.5% including Medicare levy.

And that very last point goes to the crux of why we undertake re-contribution strategies today. If you have a superannuation fund that is made up of $500,000 taxable component and you have no one else to leave it to except your adult and financially independent children, then they will pay $82,500 in death duties!

The second important reason is that if you are under age 60, then any income stream you receive from superannuation is treated as assessable income (less the 15% rebate). So if you can achieve a higher proportion of tax-free component and a lower proportion of taxable component, then you pay less tax on your income stream.

Super re-contribution aims to reduce or completely remove these onerous taxes. The strategy involves:

– Withdrawing money from your super fund (cashing benefits) up to your tax-free amount; and

– Recontributing some or all of the proceeds back into super as a non-concessional (personal) contribution (subject to the non-concessional contribution cap of $150,000 pa or $450,000 if you trigger the bring forward rule).

If you have reached preservation age (say 55) but under age 60, then there is a sticking point for how much of this tax problem you can wash out. Between these ages, you can only withdraw up to $140,000 from your taxable component and pay no tax (remember that withdrawals from superannuation are not tax-free until age 60).

You may actually have to cash out a little bit more than $140,000 because any withdrawal from superannuation must be done proportionally across both the tax-free and taxable components. So for example if your fund was made up of 10% tax-free component you would need to withdraw a total of $155,555 – which is made up of $140,000 taxable component (the maximum without paying tax) and $15,555 tax-free component which is, as the name suggests, tax-free.

So just to recap: the strategy is valid, it will reduce tax payable on your allocated pension income stream and it is a great estate planning tool.

In July 2007, the ATO was queried about the potential application of the Part IVA income tax anti-avoidance provisions to the use of the recontribution strategy for estate planning purposes.

The ATO has now advised in it’s Simpler Super – Industry Stakeholder Q and A that “while it is not possible to state categorically that Part IVA will not ever be applied to a recontribution strategy that is carried out to minimise the tax that might be payable on a death benefit paid to a non-dependant, the Commissioner is very unlikely to apply Part IVA to such an arrangement.”

Furthermore, the ATO has previously stated that it is unlikely that the Commissioner would apply Part IVA to “plain vanilla” re-contribution strategies that are undertaken to minimise tax on income streams under age 60.

(Deep breath)…however (!!), this is not a strategy that you can undertake five years in a row. The $140,000 tax-free withdrawal from your taxable component is not an annual limit. Sure, the limit may increase $5,000-$10,000 over a five-year period in line with inflation and you could undertake re-contribution with this small increase, however not $140,000 per annum.

As soon as you exceed the $140,000 withdraw of taxable component and you are under age 60, you will pay tax of 15% plus Medicare on the lump sum withdrawal – which completely defeats the purpose of why you were trying to undertake a re-contribution strategy to begin with.

If you are aged 60 or over, you do not pay tax on benefits received from a taxed super fund. However, upon death, the taxable component of a lump sum death benefit paid to a non tax dependant is still taxable. So re-contribution strategies also work well if you are over 60.

We all like to minimise tax – so make sure you get great advice in this pretty technical area to do it correctly and legally.

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.

Jeremy Gillman-Wells is an Authorised Representatives of AMP Financial Planning Pty Limited | ABN 89 051 208 327 | AFS Licence No 232706.