Superannuation contribution limits

When building wealth for retirement or even building wealth for your future there are many options. Traditionally if people want to hold their wealth in tax effective structures, they consider placing money into their super accounts due to the low tax environment of only 15% on earnings.

This is, however, becoming harder with low contribution limits and the $1.6 million-member balance cap which limits large contributions to super.

If you are being taxed at the highest income tax rate of 47% (inclusive of Medicare levy) then what alternatives are there to contribute to your super account that are tax effective?

In these cases, many people have discretionary family trusts that hold their wealth and they then stream income to various family members or a company. The earnings if streamed to a company may be taxed at between 30% to 27.5% and, if paid to other family members the progressive tax rate from nil tax to 47% tax.

The problem with the use of the company to retain income and cap the tax rate arises where considerable earnings are achieved on wealth. In this case, the company then builds up significant retained profits that if ever paid out in large sums can then result in what is called top up tax. Top up tax is the difference between the tax the company pays and the tax rate of the individual. The tax on these large payments may be as much as 17% bringing total tax back to 47% on this wealth. For example, a company with retained profit (income) of $700,000 with a franking credit of $300,000 (effectively taxable income if paid out of $1 million) if paid out to people on the highest tax rate would attract a further tax of $170,000.

Many people don’t know about investment bond tax structures which allow wealth to be accumulated on a flat tax rate on earnings at 30%. If the required conditions are met over a 10-year period, this then allows the capital and future retained earnings to be paid out to the owner of the investment bond with no further top up tax. This allows wealth to be built just the same way as in a company limiting the tax on earnings but there is no additional tax on withdrawal.

There are limitations as to how the wealth in an investment bond is invested and it is limited to be invested in managed funds. Unlike in a company, this wealth can be invested in almost anything.

As a worked example let’s assume, we accumulate over 10 years, $2 million in a company in a portfolio and $2 million in an investment bond portfolio. Assuming a modest return of 5% let’s see the difference in tax outcomes if the earnings are drawn on each year. Note – we will ignore franking credits as both structures benefit from this tax anyway and would get the same reduction in tax. The real benefit is the additional tax paid by an individual after being paid the income if their other income is already at $180,000 p.a. Also, it is noted if the company is on a 27.5% tax rate the individual then pays the difference personally raising their top up tax to 19.5% from 17%.

Total tax saved yearly in this example would be $17,000.

Another benefit with investment bonds is they do not form part of a person’s estate in the same way super does not. This allows this wealth to be passed directly to beneficiaries on death or even before death with no tax consequence to them or the beneficiary. As it is not part of the estate it is not part of the contestable wealth of the deceased. This is a benefit in situations where people are in a relationship with children from previous relationships and they want to ensure the right people receive part or all of their wealth on death. They do not want their current spouse, former spouse or children to have the ability to contest their estate and take most of their wealth which they otherwise could do with wealth held in other tax structures.

A further key benefit of this structure is it is a legacy type of life insurance tax structure which means if left on death or while alive to an overseas beneficiary they may be able to draw on this with no Australian withholding tax consequences. It has also been identified some overseas tax authorities recognise the life insurance nature of the Australian investment bond and may also not tax the drawings received by the beneficiary.

There is a lot to understand with how to best utilise an Investment Bond and advice should be sought before entering one as there are costs that can rule them out as being effective on low balances.