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The transition to retirement (TTR) pension has often been viewed as a significant planning opportunity for people reaching the end of their working career and finding they may need one final ability to ‘top up’ their super before pulling the pin and entering the world of retirement fully.
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However, from 1 July 2017, as part of the most substantive changes to super pensions since 2007, TTR income streams have been ‘re-vamped’ with the intention of better aligning this income stream to its original purpose.
This article will revisit the various common uses of TTR income streams, whether those uses are now viable and what benefits these income streams can provide post 1 July 2017.
What are the changes?
The two key changes impacting those who may be looking to use a transition to retirement income stream are:
Earnings on investments backing a TTR income stream will no longer be exempt from tax. As a result, earnings on these investments will be subject to tax at the standard accumulation rate of 15 per cent; and
The concessional contributions cap is reducing from $30,000 or $35,000 for those 49 or over on 30 June 2016, to $25,000 for 2017/18, regardless of age.
The removal of the tax exemption of earnings on TTR income stream assets was introduced to remove the ability for people to transfer their super benefits into a tax-free earnings environment whilst they are still working.
As the superannuation system is defined by the ability to access tax concessions to help fund your retirement (or as the Government’s proposed objective for superannuation states, to supplement or substitute the Age Pension), the Government feels it is better targeted to have pre-retirement income streams for everyday Australians taxed at the same concessional rate as accumulation interests.
Whilst not directly related, the reduction of the concessional contributions cap impacts one of the more common uses of TTR income streams.
Since the introduction of the new contribution cap system in 2007, the concessional contributions cap is roughly one-quarter of its original value.
In fact, the cap has been reduced to a point where the recent superannuation reforms have modified the maximum earnings base (that is, the maximum salary at which an employer is required to pay the superannuation guarantee), such that this base is now the less of the indexed base, or the concessional cap divided by the super guarantee (SG) rate.
The effect of this simply stops employers from paying more SG than the concessional contributions cap, however, it also indicates that the ability for people to save beyond their mandated employer contributions through tax-effective super contributions may be limited going forward.
How are TTRs generally used and how will this change?
Considering the average super account owner, there are three main reasons transition to retirement income streams have been used in the past.
Transitioning to retirement
Arguably the original intention of the TTR pension was to enable people who were over preservation age to reduce their working hours and allow them to experience some of the joys of retirement, whilst still being able to receive the same level of income and extend their work-force participation.
In other cases, some people have used TTR pensions to enhance their personal cash flow whilst still working full-time to help consolidate debts or meet other expenses – helping ‘clear the way’ for full retirement.
Changing the taxation on TTR pension earnings does not fundamentally derail the use of this income stream for these purposes.
The ancillary benefit of having tax-free earnings (which could result in a substantial tax saving) is not the main reason for the pension to exist. Going forward, TTR pensions will still provide the ability to access a tax-effective income stream for those looking to reduce their working hours or finish paying off the mortgage before retirement.
Salary sacrifice and cash flow management
A common financial planning strategy using transition to retirement pensions involves both a combination of increasing pre-tax contributions to super and supplementary TTR pension income to maintain a similar level of personal cash flow, whilst minimising tax and saving more in retirement.
Typically, this strategy involves salary sacrificing employment income to super, and using a TTR income stream to top up a personal cash flow, so the amount of after-tax dollars is the same, but since transition to retirement income is concessionally taxed, it is possible to create a tax arbitrage – the benefit of which is captured in super.
Once again, the benefit of the strategy is not driven by the tax savings on TTR assets, however, another change to super reduces the effectiveness of the classic TTR strategy.
That change is the reduction in the concessional contributions cap.
From 1 July 2017, the concessional contributions cap for everyone will be $25,000 – down from $35,000 for those 50 or older, or $30,000 for those under 50. For context, this is one-quarter of the transitional contributions cap brought in on 1 July 2007, 10 years ago.
Relevant to this discussion, however, is the ability to salary sacrifice. Given a 9.5 per cent super guarantee rate counting towards the concessional contributions cap, the ability for many people to make significant additional contributions beyond their super guarantee monies will be lower.
Like many super strategies, salary sacrifice contributions are more effective for higher income earners (at least up to $300,000 this financial year and $250,000 next year).
Given earnings are no longer tax free, the question comes down to the level of tax savings that can be achieved by replacing employment income with TTR income. Pension income is taxed differently depending on the age of the recipient.
For persons over age 60, their TTR pension is completely tax-free, meaning the tax saving which is able to be achieved is the client’s marginal tax rate (i.e. the tax that would have otherwise been paid on the salary sacrificed income), less 15 per cent (the tax rate which applies to the salary sacrificed income).
However, those under 60 have the taxable component of their pension taxed at their marginal tax rate, with a 15 per cent offset. If a person has a TTR pension which consists wholly of taxable monies, there would be no tax benefit gained, since the 15 per cent tax paid on the contribution offsets the TTR tax rebate – resulting in the same tax outcome.
Given this, the benefit of a TTR strategy for someone under age 60 is reliant on the tax-free component of their super benefit, as this is not taxed even under age 60.
There’s a final complication for those under 60 that can come into play in determining the amount of capital used to commence a TTR pension.
If a client has significant super capital, the minimum pension that would be required if they used their full super savings to start a pension could exceed the level of income which would be needed to replace the salary sacrificed income.
Since the aim of the strategy is to obtain a tax benefit, forcing the client to receive a higher level of taxable income by maximising the capital value of the pension, could unwind the tax savings provided by the strategy.
Consequently, a lot of consideration should be given to the purchase price (the starting value) of the pension under current rules and this will be a key consideration in the new regulatory environment, where additional personal taxes cannot be offset by savings on investment earnings.
On this basis, the combination of the lower concessional contributions cap, the complexity and costs of maintaining a second super account for the TTR pension and now, the loss of the tax-free earnings, will for many people result in this use of the TTR pension being relegated to the ‘nice but not widely applicable’ corner of the financial planner’s toolkit.
Accessing tax concessions
The final common use of TTR pensions are those pensions started by people who may not need the additional cash flow, but do seek a tax-free earnings environment for their super capital.
Given that a TTR pension has a minimum pension drawdown, which must be paid each year, either the earnings on the transition to retirement would have to exceed 4 per cent or the person needs to have capacity to recontribute the pension payment back to super to ensure their desire to obtain a tax-free investment vehicle is not undone by the pension payment ‘leakage’.
Some individuals have used their transition to retirement pension payments as part of a ‘withdrawal and recontribution’ strategy to increase the tax-free portion of their super benefits over time. They do this by drawing on their mostly taxable component of the TTR pension and re-contributing this as a non-concessional contribution, increasing the tax-free component of the client’s combined super benefits.
Arguably, the removal of the anti-detriment payment would highlight a need to reconsider withdrawal and recontribution strategies in general, to help minimise the tax burden for non-dependent beneficiaries, particularly adult children.
However, now that capital gains realised within a TTR pension will be taxed at up to 15 per cent, the tax paid on the redemption of assets to physically pay the funds out of super using a TTR pension to undertake this strategy, may not provide an optimal outcome.
Overall, using a TTR pension to simply access tax-free earnings will not be a strategy available from 1 July 2017. However, some clients may still use a TTR pension to implement a withdrawal and recontribution strategy.
What benefits do TTR pensions have going forward?
Whilst the tax changes reduce the benefits of a TTR pension, one key point is sometimes lost in the noise – and that is a TTR income stream is still a pension. Pensions are separate interests to accumulation accounts and provide some unique benefits relative to accumulation accounts, which are separate to the tax treatment of both the investment income and pension payments.
Firstly, a SMSF is only able to have a single accumulation interest for each member, however, they can have many separate pension interests. This allows for tax component isolation strategies where TTR pensions are commenced to potentially separate tax-free monies from future taxable contributions.
Another benefit of pensions being separate interests is in dealing with death benefits. Each unique pension can have a separate death benefit nomination, and TTR pensions can also have reversionary beneficiary nominations to ensure the income stream passes to the intended beneficiary smoothly, should the income from the pension be required to meet the beneficiary’s day-to-day costs, and an interruption in that payment may cause issues.
Finally, as a pension, the tax components of a TTR pension are locked in their proportions on commencement. This could be a double-edged sword, relative to accumulation accounts that have a fixed dollar tax-free component and investment return impacting only the taxable portion.
If the pension value increases over time, the dollar value of the tax-free portion would increase as well. However, poor investment performance will reduce the absolute value of the tax-free portion, since the proportion is locked, not the fixed dollar figure. However, given an appropriate investment timeframe and portfolio selection, it may be possible to reduce the risk of permanently losing tax-free monies.
Though the humble TTR pension may not have the pride of place in the planner’s toolkit post 1 July 2017, that is not to say this pension does not have a place in the new world. Individuals who require tax-effective income may still look to transition to retirement pensions for this, and over age 60 salary sacrifice strategies using a TTR pension may still be viable.
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