This week’s episode is another one inspired by a recent client question, one that we get asked multiple times each year.
Should I be topping up my super?
The primary motivation in seeking out an answer to this question is to determine whether you’re on track to have enough retirement savings for a comfortable and enjoyable later phase of life.
But the other element is around tax.
There’s a general awareness that there are tax savings to be had through using the superannuation system. The unsaid element to this question of topping up super, is whether potential tax savings are being squandered through not taking maximum advantage of the superannuation system?
Before we dive in, it’s appropriate that I remind you that the information contained in this podcast is general in nature, and of course does not take into account your specific circumstances. Australia’s superannuation system is complex, and the dollars involved can be significant, so consider getting professional advice that is specific to your circumstances before making any changes to your superannuation arrangements.
Super’s Attraction
Let’s begin by ensuring you have clarity on why Australia’s superannuation system is attractive to use to fund your retirement.
The main game here is generating tax free income in retirement. Throughout your working life you accumulate superannuation savings, most of which are likely to be through compulsory employer contributions. At some point beyond the age of 60, you retire and convert those superannuation savings into a regular income. That income is paid out to you tax free.
This is significant because it means there’s no leakage. Let’s say at the moment you earn $120,000 in your job. After tax, you have about $88,000 available to spend. Flipping this then, if you need $88,000 a year to live a comfortable life, whilst you are working and paying tax you need to generate $120,000 to make this happen. In retirement however, to have $88,000 per year available to spend, you need only draw down that exact amount from your retirement savings. There’s no leakage going out in tax. This is means the amount of wealth that you need to accumulate to fund a comfortable retirement is considerably less within the superannuation system, than if you were to fund yourself in retirement outside of super.
But whilst tax free income in retirement is the ultimate benefit, that’s not the only tax advantage granted when you make use of superannuation.
Whilst you are working, taxes on the earnings within your super fund are 15% on income and 10% on capital gains. For most people this will be considerably less than were they to hold equivalent investments outside superannuation in their personal names.
Superannuation is also tax free when paid out to a spouse should you pass away. This differs from ordinary non-super investments where capital gains tax may be payable in the event of a change of ownership.
The drawback
Superannuation then is very attractive for accumulating wealth to ensure you are financially secure later in life. But there’s no such thing as a free lunch. Superannuation does have one drawback, and that is something called “preservation”.
Your superannuation savings are preserved, that is inaccessible, until you are at least 60 years of age, and retired. This means that money you put into super must be money you are confident won’t be required until later in life.
Contribution Caps
As I mentioned in the introduction, our superannuation system is complex and I can’t go through all the fine detail in this podcast. But one key element that you should be aware of when considering the question of topping up your super is contribution caps. In particular, concessional contribution caps.
Concessional contribution limits relate to contributions made where a tax deduction is claimed. Primarily these are your employer superannuation contributions, but this cap also picks up contributions you make either via salary sacrifice, or claiming a personal deduction.
At present the concessional contribution cap is $27,500 per year. Contributions made in excess of this limit can have penalty taxes applied.
Your employer will automatically contribute 10.5% of your wage into superannuation. The first thing you need to do when contemplating making top-up super contributions is ascertain how much of your contribution cap is already being used up through your employers contributions. How much headroom do you have within the cap?
Tax
I’ve already mentioned that our superannuation system has several tax benefits. If however, you pay little or no tax, then these benefits might be of no value to you whatsoever. In fact it may well be that the tax paid on your top up superannuation contributions is greater then had you simply retained the funds in your own name. Layer on top of this the preservation element that you’ve now subjected to your money to, and you are distinctly worse off.
As a rough rule of thumb, if your taxable income is under $45,000, there’s very little benefit in you making top up concessional superannuation contributions. There might well be strategies where you make lump sum after tax contributions as you get close to retirement, but salary sacrificed type top-ups are likely to see you pay more tax, or at least generate minimal tax savings, relative to simply investing the money in your own name.
Alternatives
When I talk to clients about the advisability of making top-up superannuation contributions, a key consideration is what alternative uses those funds could be put to. Most commonly this concerns the mortgage.
Top up super contributions produce tax benefits, but at the expense of losing access to your money for many years. Quite often it might be more advisable to focus any savings capacity towards paying off your mortgage, in preference to making extra superannuation contributions. Whilst there is no immediate tax benefit, taking this approach guarantees an effective return of whatever your mortgage rate is, at present likely somewhere around 6%.
We’ve all played with the calculators that show the amount of interest saved when we pay an extra couple of hundred dollars each month onto the mortgage. And once your home loan is paid off, you might then consider making top-up superannuation contributions provided you have enough room within the caps.
For someone with an early retirement goal, they may also prefer the alternative of investing outside superannuation in their own name so as to have the flexibility of access to their savings.
Top-up later?
Whilst thinking about alternatives, we should also consider the opportunity to top-up your super via larger lump sums later in life.
I’ve mentioned that the concessional contribution cap is $27,500 per year. There is a second cap called the non-concessional contribution cap. This is for after- tax money and currently sits at $110,000 per year. You can even do three years worth of this contribution in a single year in some circumstances.
There are also provisions for those who downsize their home, something that frequently happens after retirement. Under the downsizer provisions, you could add $300,000 to your super as a lump sum. And this is per person, so if you’re part of a couple then between the two of you that could be double.
The magic of compounding means that it is attractive to get money invested earlier rather than later. But in the case of superannuation, preservation is a significant counter-weight.
It may well be that the best approach for you is to focus on paying down a mortgage, and then looking to boost your super as you get closer to retirement. This is with the knowledge that your employer is already contributing 10.5% of your wage, so your superannuation is being built up in any event. If you’re self-employed, you need to be thinking about things a little bit differently, and likely at least trying to replicate what would have gone into your super were you an employee.
How much do you need?
Finally, when trying to decide whether you should be topping up your super, it’s worth reflecting on how much superannuation savings you actually need.
The starting point is to estimate how much retirement income you require. From here you can play with the calculators in MoneySmart and get a rough estimate of how much retirement savings you would need to produce your target level of income.
Armed with this target figure, crunch the numbers on where you would expect your superannuation to be at retirement, given its current balance and future employer super contributions. You might find that in fact you’re already on track to have all the superannuation savings that you need, in which case sacrificing now to contribute more into super might be a wasted opportunity. It would be pretty disappointing to have far more money than you need when you’re 95 years old and in poor health, and for that to have come about through you making sacrifices in your 30s or 40s when you were fitting well and could have been out having a whole lot of fun.
If you need some help crunching the numbers, do reach out. That type of analysis is core work for us.
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