Are allocated pensions all that they are cracked up to be?

My question is about allocated pensions. As I understand it a person between the age of 55 to 60 yrs, can reduce the tax paid in his super fund from 15% to zero by entering an allocated pension. However could you consider this self-defeating if say the person did not need that pension to live on? Thus the draw down on the balance of the super fund would offset the super funds tax saving.

Response:

Arrhhh, the magic of tax arbitrage!! You are spot on in that it would not make sense to draw down on money not required, especially seeing as most super funds actually pay closer to 7% tax, rather than the maximum 15% – so the saving by switching to allocated pension is not as much as it first appears.

Furthermore, if you are under 60, then you may be paying tax on the income received from the allocated pension, so this would have to be taken into account in any analysis.

Let’s say you have $500,000 in super accumulation phase and it earns income of $25,000 (5%). Then the maximum tax you will pay is $3,750 – 15% of the earnings. You may decide it is worth paying the tax because you don’t need the pension income stream – which you would be forced to take at a minimum rate of 4% or $20,000 pa – which in turn, may be taxed anyway. And remember once it’s out of super, any earnings from the $20,000 invested in your own name, will be taxed at your marginal rate.

However, the fundamental advantage to starting an allocated pension once you hit 55 is the not the difference inside superannuation/allocated pension (especially for those between age 55-60), but rather outside the superannuation environment.

The Transition to Retirement (TtR) income swap strategy involves an individual who has reached their preservation age (say 55), swapping their marginal tax rate income from wages or their own business, with a highly tax effective allocated pension from their superannuation.

Here’s how it works: instead of receiving your highly taxed marginal rate income (say at 41.5% including Medicare) in the hand, you salary sacrifice (or if you are self employed, make personal deductible contributions) a vast bulk of this income to super and only pay 15% contributions tax. You can afford to do this and still live because you are receiving a highly tax effective (read somewhere between 0% and 15%) income stream from your new allocated pension.

So in this example, the income swap has achieved an overall tax saving outside super of around 25%. The small tax saving on earnings in super versus no tax on earnings for an allocated pension is a bonus – it’s not the main game.

When all these benefits are combined, the growth in your total retirement benefits is accelerated. Let’s illustrate this with a case study…

Jack, age 55, is employed on a full-time basis and earns $95,000 per annum. His current superannuation balance is $200,000 (all taxable component). Jack would like to retire at age 65 and would like to boost his superannuation savings over the next 10 years. However, Jack is unable to increase his superannuation contributions due to his current lifestyle commitments.

We recommend that Jack negotiates with his employer to salary sacrifice $25,128 of his income into super. So he can maintain his lifestyle, Jack starts a TtR allocated pension with his entire superannuation proceeds of $200,000. This will provide a maximum income of $20,000 (10%) in the first year.

But how will the strategy impact on Jack’s take home pay?

Salary Sacrifice

Jack’s take-home pay remains exactly the same – however his income tax savings outside super are significant.

As Jack’s focus is on growing his superannuation benefits, what impact has this strategy had on his benefits?

And over the 10 year period until retirement, the increase will be much more significant. Once Jack is 60, the allocated pension income stream becomes completely tax free, giving more income in the hand. Correspondingly, to keep take home pay the same, the salary sacrifice can be increased, further adding to the accumulated final retirement benefits.

Coming full circle, this is only half of the story! By commencing a TtR allocated pension, Jack has ensured that any earnings on the $200,000 invested in the pension will not attract any tax (as compared to the 15% tax rate had he left the money in accumulation phase).

So, over the 10 years to age 65, the combined effect of the increase to super each year and the earnings on the pension assets being tax exempt, enhances Jack’s retirement position at age 65 as follows:

Jack’s retirement position at age 65 has been improved by $66,657 (or 16%) as a result of the TtR income swap strategy, and this was achieved without a decrease in his take home pay (and has nothing to do with investment returns – simply tax arbitrage).

Finally, the higher the income and the higher the starting superannuation balance at age 55 and less money you need to live – the better it gets!

Note that income streams commenced under the TtR condition of release are non-commutable. This means lump sum cash withdrawals are not permitted until a condition of release is met. Also, the income level drawn from a TtR income stream will be limited to a maximum of 10%, and a minimum 4%, of the account balance.

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.