Unscrambling the Superannuation mess

I'm going to quickly propose a better alternative.

man and woman discussing superannuation

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This Super mess?

Because that's what it's become. A Super – and super – mess.

We started the week with the Federal Government saying that it might be fair to wind back tax concessions on multi-million dollar Super balances.

Fair enough. Taxing a $3 million super balance at 15%, while wage-earners were paying marginal rates of 21%, 39% or 47%, is… generous.

We want people to build retirement savings, of course. But above a certain level, the taxpayer shouldn't be subsidising it.

That concept, and the $3m balance level, got broad public support, even if begrudgingly in some quarters.

So unremarkable and reasonable was it, the AFR editorialised in favour, and The Today Show lampooned people who were complaining about it.

Then the wheels fell off.

Yes, politically, but that's not my specific interest, here.

They fell off, economically, as well.

First, setting a tax rate on a 'balance', rather than an 'income level' is… not ideal.

A Super account with $4m, made up of property yielding, say, 2%, would pay a marginal 30% tax rate on their $80,000 income.

Someone with $2.5m in shares, earning a dividend yield of, say, 6%, would pay a marginal tax rate of 15% on their $150,000 income.

Which is… strange.

Then we found out the $3m won't be indexed. So, as incomes, Superannuation contributions, and investment returns compound over time, more and more accounts will be caught by the cap.

Remember, Super will compound over a lifetime of 40 – 45 years of work. A $3m cap for someone at 65 now is pretty reasonable. But will it still be reasonable in almost half a century when prices and wages are much, much higher. Probably not.

That is… problematic.

It got worse…

… and this is the piece de resistance.

The Treasury announcement confirmed that the tax would be levied on fund returns, which included unrealised capital gains. What's an 'unrealised gain'? It's the increase in value of an asset, even if that asset isn't sold.

So, back to our previous $4m example – if the property increased in value by 10%, the ATO would take that $400,000 'gain' and ask the Super fund to pay tax on it – even though no money had changed hands.

That's not only almost-unique in our tax system, but… ridiculous.

So here we are.

From almost universal (if in some quarters begrudging) acceptance and support for a reduction in Super tax breaks, the Government had delivered a policy that was as controversial as it was complex and, frankly, poorly designed.

(And, back to the politics for a second, was a political gift – with a large bow – for the Opposition).

Now, I'm not sure what is more likely: that the Government was poorly advised, that Treasury got ahead of itself, or that the Government actually meant all of these things, in full knowledge of the implications.

Because let's be clear:

Using a balance, rather than income level, to set tax rates, would be a huge policy departure (Assets tests are used for some benefits, so it's not entirely new… but using it to set tax rates would be a big, bad, jump).

Using unrealised gains, in concert with the fund balance, essentially makes this a wealth tax, not an income tax – another piece of new ground.

And using an un-indexed balance cap means the program is designed to capture more Super funds every year.

If the Government takes the view that those things were deliberate, and that they knew exactly what they were doing, it paints a very clear picture. In that scenario, it'd be hard to escape the view that they're essentially putting a de facto cap on Super at $3m. Anything above that, and you're subject to not only a higher rate, but a tax bill on unrealised gains that might be larger than the fund's cash flows, essentially forcing some/many people to liquidate assets.

Again, this is an 'if', but at that point, many, perhaps most, people will reduce their Super balances to below that threshold. As I said, a de facto total cap on Super.

And perhaps we've been tricked into agreeing with the headline idea – removing concessions for large balances – and getting sucker-punched by the detail.

So, if this is deliberate, it is not just 'taxing large funds a little more', but radically resetting Superannuation.

And if it's accidental? Then it's hard to escape the view that the Government has been poorly advised, having let the econocrats loose on policy, with insufficient consultation with outside experts.

I'm not sure which is more likely, but neither looks good, from where I stand.

And again, remember I'm someone who has been loudly agreeing with limiting tax concessions where they're not absolutely needed and too costly.

Frankly, I hope it's accidental. They can say 'we were hasty, let us consult and improve things'.

If it's deliberate? Then it's bad policy, advocated with a bait-and-switch PR campaign. And that does them no credit.

Now… while I'm mindful that I've already written quite a lot, above, if you're interested (and you should be – this will impact increasing numbers of people!) – I'm going to quickly propose a better alternative.

It's this simple:

1. All Super accounts are tax-free during our working lives until and unless the balance hits $1.7 million (giving lower income earners the best possible chance of maximising Super)

2. Index the $1.7 million to CPI each year.

3. Once over $1.7m, the fund becomes taxable at 20% of realised gains.

4. Once the member is over 65, the fund must distribute a set percentage of its capital to the member (probably 4% per year).

5. The fund distributions are taxable in the hands of the member, at that member's marginal tax rate.

6. Every Australian over 65 would get the aged pension, which would be taxable income; but

7. Set the tax free threshold for over 65s at $10,000 above the aged pension level.

What would this do?

A lot. And very, very simply.

First, it rewards saving for retirement.

Second, it gives lower income earners the very best chance to retire with enough Super.

Third, it limits the cost of concessions for higher income earners.

Fourth, it stops Super being used as a tax shelter (by requiring withdrawals and taxing those withdrawals appropriately).

Fifth, it hugely reduces the stupid complexity of the Superannuation system with its various rules and perverse incentives.

And sixth, it removes disincentives for older Australians to dip in and out of the workforce as their circumstances allow / require.

Perfect? No.

Contentious? Yes.

Could it be improved? Probably… and if you have better ideas, let me know!

But doesn't it seem a helluva lot better than the current tangled mess of incentives and disincentives, with so many different rules and processes that you almost need an accountant on speed-dial just to understand it?

I think my proposal is simple, workable, and achieves all of the aims of Super. It stops it being used as a tax shelter, and reduces the administrative complexity (and cost) enormously.

So… it probably will fall on deaf ears! But just in case…

Treasurer Chalmers, this hasn't been your best week.

Give me a call. Let's chat. I'd love to help.

Fool on!

Motley Fool contributor Scott Phillips has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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