By the time retirement is reached, most individuals will have paid a significant amount in tax over their working lives. Therefore, you owe it to yourself to structure your affairs to minimise (or eliminate) tax once you stop working. Fortunately, there is enormous scope to manage your tax position in retirement, particularly with respect to superannuation.
Below are 7 strategies you can use to reduce tax in retirement.
Commence an Account-Based Pension
This is a common strategy to reduce tax in retirement. When you commence a pension from your super fund, the 15% tax applied to fund earnings is removed. In other words, fund earnings become tax-free once you commence a pension from your fund. Additionally, if you are aged 60 or more, the pension income is also tax-free, regardless of the amount of income you draw.
For those aged 55-59, fund earnings will also be tax-free but there may be a small amount of tax to pay on pension income prior to turning 60. If considering this strategy however, you need to be aware of the minimum annual pension payment factors. These specify a minimum percentage (of your fund balance) that you need to draw as income for the year. The minimum percentage increases with age. With this in mind, if you have income from other sources, you may end up with more income than you actually need and if you are over age 65, you may not be eligible to re-contribute the surplus back into superannuation.
Consider using a self-managed super fund (SMSF)
A SMSF provides far greater scope and flexibility for tax planning compared to other super funds. Because of this, if you have a SMSF, you will have more avenues available to managing tax during (and leading up to) retirement. A common scenario for those without an SMSF is commencing an account-based pension to eliminate the 15% earnings tax where there is no need for pension income which must be drawn with respect to the minimum payment factors (as discussed above). This situation effectively forces a withdrawal of funds from superannuation before the 15% earnings tax is removed. Because of the increased tax-planning flexibility afforded by SMSF’s, this situation can often be avoided.
Having complete control over fund investments and being able to ‘time’ buying and selling decisions is key with most tax-planning strategies within an SMSF, and this situation is no different. The franking credits received from Australian share dividends can often be used to offset the 15% earnings tax when the fund lodges its tax return at the end of the year. Franking credits (also known as imputation credits) represent the company tax already paid on a dividend before it’s paid to shareholders.
The company tax rate is currently 30%, meaning the franking credit is also equal to 30%. It’s worth noting that where franking credits (in dollar terms) exceed the amount of earnings tax payable for the year, the unused amount is not wasted. The ATO will, in fact, include a refund for this amount in the fund’s tax return. Simply put, not only have you eliminated all tax on your SMSF for the year, the ATO has actually given your super fund a refund!
Take Advantage of Tax Offsets and Rebates
Once retired and aged 60, income from a superannuation pension is not your only avenue to receiving tax-free income in retirement. If you are Age Pension age (currently 65 for men and 64 for women), you may be able to apply the Senior Australians Tax Offset (SATO) and enjoy a higher tax-free threshold. For the 2011/12 financial year, singles can earn up to $30,685 and couples $26,680 each without paying any income tax. If you are under age 65 and retired, you can take advantage of the $6,000 tax-free threshold and the low income tax offset (LITO) and earn up to $16,000 (2011/12 financial year) without paying income tax. Therefore, you may be able to retain some assets (e.g. a rental property) outside superannuation and still receive income from them tax-free during retirement.
Consider Selling Assets and Transferring the Proceeds to Super
Liquidating assets and contributing the proceeds to superannuation may reduce tax and simplify your estate planning arrangements. This strategy is often even more appealing if you have a self-managed super fund (SMSF) (as discussed above). Once you commence a pension from your super fund, pension income will be tax-free if you are age 60 or over. If you hold significant assets outside superannuation, the income generated from them may still be taxable once you retire. Additionally, assets outside superannuation will form part of your estate and will be distributed to beneficiaries in accordance with your Will.
Superannuation generally does not form part of your estate, it is payable to beneficiaries directly (in accordance with separate beneficiary nominations) as a lump sum, pension or combination of each. And because superannuation is a type of trust, asset protection is provided. This simply means that superannuation monies are generally protected after your death (e.g. from creditors or from a challenge to your estate). Furthermore, superannuation benefits are usually distributed to beneficiaries quickly, whereas estate assets cannot be distributed until probate has occurred.
Time the Sale of Assets to Reduce CGT
If you hold assets outside super (e.g. shares) and there are significant capital gains, you could consider timing the sale of such assets to reduce the amount of capital gains tax (CGT). The proceeds may then be contributed to your super fund as concessional or non-concessional contributions (if you are eligible to make such contributions). For this strategy to be effective, you need to calculate the amount of taxable income you will receive each year and understand how this relates to your tax-free threshold (or marginal rate of income tax).
As capital gains are added to your taxable income at the end of the year, you can then establish the optimal amount of capital gains for the year and liquidate (in the case of shares) the appropriate number of units to achieve your desired result. This process can be repeated for as long as you are eligible to make contributions to superannuation. If you were intending on selling the asset(s) in the future anyway, you could reduce your future CGT bill by using this strategy now. If you were intending on passing the asset(s) to beneficiaries, you may save them tax in the future because super funds don’t pay CGT once you have commenced a pension. Remember to account for the 50% CGT discount if you have owned the asset for more than 12 months.
Make Deductible Contributions to Super
If you are retired and under age 65, you may be eligible to make personal contributions to superannuation and claim a tax deduction for them. If you are paying income tax in retirement, this strategy will reduce your taxable income and therefore the amount of income tax you pay. It will also boost your super account balance and therefore the amount of tax-free income available if you start a pension at age 60 or over.
However, you need to be mindful that deductible contributions will incur 15% contributions tax within your super fund and that such contributions will count towards your annual concessional contribution cap. If you exceed this cap in a given year the ATO may ask you to pay penalty tax on the excess. Furthermore, you also need to consider the tax implications of concessional super contributions with regard to your estate planning objectives. For example, if your beneficiaries are non-dependent adult children, they may have to pay tax upon receipt of your superannuation benefits after you pass away.
Consider a Re-Contribution Strategy to Reduce Tax
A re-contribution strategy can reduce tax for your beneficiaries after your death. If you are retired and have reached preservation age (55-59), you can consider withdrawing a lump sum from your super fund and then re-contributing it as a non-concessional contribution.
By doing this, you are increasing the amount of non-concessional component in your super fund and reducing the amount of concessional component. Non-concessional amounts are tax-free in the hands of beneficiaries after you die, concessional amounts may be subject to tax.
If you are under age 60 and considering a re-contribution strategy, you need to ensure your withdrawal does not exceed the low rate cap applying to lump sum benefits. Tax will apply to any excess amounts. Additionally, when re-contributing the amount to your fund, you should consider the annual non-concessional contribution cap (currently $150,000) and triggering the bring-forward rules if your contribution exceeds this amount. The bring-forward rules allow you to bring-forward contributions for the next 2 years, meaning you are able to contribute up to $450,000 in a single year.
The strategies above are complex in nature and whether they are suitable for you will depend on your individual circumstances. ICG Financial Planners Melbourne specialises in retirement tax planning, contact us or call today on (03) 5974 4350 and find out what strategies are right for you.