A fresh look at recontribution strategies
Applying cash out and recontribution strategies can have significant advantages for clients affected by the transfer balance cap, but it's critical practitioners implement them early on.
Following the introduction of the transfer balance cap (TBC) and total superannuation balance, many advisers are now considering what steps clients will need to take to ensure that they are maximising their opportunities under the new retirement system.
Given that the majority of retirees want to travel the world and then leave a healthy legacy to their dependents, we need to consider the steps that need to be taken to maximise the benefits that fall within the TBC and that can be used to commence a retirement phase pension in retirement.
In most cases this can best be achieved by ensuring that the individual members of the fund maintain their individual member balances below the TBC and total superannuation balance.
This will ensure that both concessional and non-concessional contributions can continue to be made to the fund, whilst the member is eligible to do so, and that when a retirement phase pension commences it will fall entirely within the TBC.
The most commonly used strategy for achieving this is the cash out and recontribution strategy, which when properly implemented, will have the impact of equalising accumulated superannuation benefits between spouses. At the same time it reduces the potential tax liability payable when accumulated death benefits are distributed to non-tax dependents following the death of a member.
What is the cash out and recontribution strategy?
This strategy involves a member withdrawing a super benefit, which contains a taxable component from their fund. This amount is then recontributed to the fund as a non-concessional (tax free) contribution for the benefit of the spouse with the lower account balance.
For example, David (62) and Karen (58) are married members of the Purple Superannuation Fund. David has accumulated superannuation benefits of $2.6 million, while Karen’s has accumulated benefits of $400,000. Neither member made any non-concessional contributions in the three years prior to 30 June 2017.
David’s benefits are made up of two TRIS pensions, TRIS #1 is $1.8 million and is 90 per cent tax free and TRIS #2 is $800,000 and is 10 per cent tax free.
David has decided to retire and convert his transition to retirement pensions (TRIS) to a retirement phase pension and has come to his advisor to confirm that he is taking all steps necessary to maximise his retirement benefits.
If no changes are made to David’s arrangements, he will need to commute part of his TRIS to a lump sum in order to comply with the TBC, which will limit his retirement phase pension to no more than $1.6 million.
This means David’s remaining benefit in the fund will either have to be withdrawn from the fund as a lump sum or held within the fund as an accumulation interest. If the benefit is held as an accumulation interest, the income earned on this interest will be taxed at 15 per cent, as opposed to a 0 per cent tax rate that applies to income derived on pension assets.
Under the cash-out and recontribution strategy, David is able to withdraw $300,000 during the 30 June 2018 year and gift this money to Karen who makes a non-concessional contribution for her benefit.
So what are the benefits of adopting this strategy? On the face of it all we have done is transfer $300,000 in benefits which is taxable in David’s superannuation account, to Karen’s superannuation account where it continues to be taxable.
However, the real benefits of the strategy emerge in future years after Karen has retired. At this stage, her accumulated benefit of $700,000 at 30 June 2018 continues to be subject to income tax as she has not retired.
However, when she does retire and commences a retirement phase pension, the entire balance will fall within her TBC and therefore the income derived on the pension will be entirely tax free.
Further based on Karen’s age (currently 58) and account balance, David would potentially be able to make more lump sum withdrawals from the accumulation account that can be recontributed for Karen prior to 30 June in the year in which she turns 65.
If the future withdrawal occurs, David’s interest in the superannuation fund will be reduced to $1.6 million and will be entirely tax free, while Karen’s benefit will have been increased to $1.4 million, which is also entirely used to pay a retirement phase pension where the pension income is derived tax free.
Are there other benefits under this strategy?
The other benefit that arises is that on withdrawal and recontribution, the taxable component of the benefit paid to David is converted to a tax-free benefit when Karen recontributes the assets as a non-concessional contribution.
The benefit arises because the taxation of death benefits paid to beneficiaries has not changed as a result of the recent superannuation reform. Adult children who are not dependants of their parents at the date of death, will have income tax withheld from the benefit at the rate of 15 per cent, if the death benefit paid to them contains a taxed component.
In the example of David and Karen, the component that David would likely hold in accumulation mode rather than pension mode is that benefit with the higher taxable component. This is because there is a benefit in holding the superannuation interest with the highest tax-free component in pension.
The benefit is, where a tax-free component is held as part of a pension interest, the earnings attributed to that interest will be allocated proportionately to the taxable and tax-free components. Which means that the tax-fee component continues to grow in pension phase in tandem with the taxable component.
Whereas if the superannuation interest with the highest tax free component is held in accumulation, all earnings are attributed to the taxable component. Which means that the taxable component grows while the tax free component remains stagnant.
Accordingly, if when David retired he elected to commute TRIS #2 and part of TRIS #1 in order to remain within the TBC, then it follows that the taxable proportion of the accumulation account will be 74 per cent taxable. This taxable component will continue to grow, as all earnings allocated to that account will be treated as tax free.
By adopting the cash out and recontribution strategy, the predominately taxable benefit held in David’s account is converted to a tax-free benefit when it is contributed to the fund by Karen.
The net result of this is that when Karen dies and her death benefits are paid to adult children, the amount of tax that they will have to pay, would have been reduced as a result of having adopted the cash out and recontribution strategy.
It can be seen that the cash out and recontribution strategy will remain one of the key strategies when it comes to assisting clients to maximise their long-term retirement goals.
However, in order for it to be effective, it needs to be applied early ensuring that where possible clients have the opportunity to equalise their account balances and to take advantage of the various caps that now apply to the superannuation system.
Mark Wilkinson, superannuation partner, BDO