The treatment of taxation liabilities hinges on the investment structure of your superannuation. That is, pooled super funds like industry funds subtract tax before it’s paid. This is an important factor to consider because, depending on the amount of your super balance, it can have a significant effect on your retirement savings.
While tax implications are crucial, there are numerous other factors to bear in mind, as outlined in the discussion below.
How tax is treated in pooled super funds
Pooled superannuation funds operate as unitised investments, where super members effectively own units in their chosen investment option, such as Balanced or Growth. Each day, the super fund must estimate the value of these units. This estimation involves using the market value of each investment and adjusting for various expenses, including selling/transaction costs, tax credits, accrued income, and any tax liabilities on unrealised capital gains. Essentially, the unit price should reflect the net value you would receive if you were to divest 100% of your balance on that day.
However, a notable drawback is that capital gain tax liabilities are deducted from your balance even if you haven’t sold any units.
To maximise investment returns, it’s advisable to minimise investment turnover (i.e., buying and selling) to reduce transactional and taxation costs because they erode your super balance. Investing in a pooled super fund doesn’t align with this goal and is one of its disadvantages.
Benefits of direct investment ownership
The solution to the disadvantage of pooled super funds is to use an arrangement that allows you to maintain direct investment ownership.
The key advantage lies in the fact that your super balance only decreases when you incur taxes or expenses. By minimising investment turnover, you can reduce taxation liabilities, thereby maximising your super balance. In fact, holding onto an investment until retirement can entirely exempt you from paying capital gains tax (CGT), as a pension-phase balance attracts a zero-tax rate.
Furthermore, an SMSF has the flexibility to delay tax payments by using a tax agent. The SMSF has until at least the 28th of February after the year-end to lodge its tax return. This means that if the SMSF realises a significant capital gain, it can postpone paying the tax for at least 8 months.
Perhaps the most significant advantage of direct investment arrangements is the full control and transparency they offer. This approach allows you to engage in evidence-based, low-cost, index investment methodologies that have been proven to yield better returns than active investment management. Additionally, the rising popularity of ethical investing (ESG investing) can be employed, as direct control enables you to avoid investments that conflict with your ethical values, such as those involving fossil fuels, weapons, child labour, and more.
Direct super investment options
If you desire direct control over your superannuation investments, there are two options to achieve this establishing an SMSF or utilising a wrap platform.
A SMSF is a trust specifically created for the sole purpose of providing retirement benefits to its members. It can have a maximum of six members, all of whom must either serve as trustees or be directors of the trustee company. The SMSF entails various obligations, as detailed in this ATO booklet. The primary compliance responsibility involves preparing audited financial statements and filing an annual tax return. Of course, you need an accountant to do this for you, which I discuss further below.
A wrap platform is an individual super account that provides access to a diverse range of investment options, typically including managed funds, ETFs, and listed shares. The wrap provider handles all administrative tasks, making it less cumbersome compared to managing an SMSF. The only thing you need to do is decide how to invest your balance. I discussed wrap products here a few years ago.
Which direct investment option is best?
I usually suggest considering the establishment of an SMSF primarily if you’re interested in investing in unlisted assets such as direct residential or commercial property, unlisted property trusts, and art/collectibles. If these types of investments are not required, a wrap platform will be a lot more cost-effective and won’t attract the compliance burden SMSFs do.
It is worth mentioning that SMSFs provide distinctive estate planning advantages, making them suitable for individuals with more complex circumstances, such as blended families or special-needs beneficiaries.
Consider components of total return
The primary goal of investing is to maximise returns on an after-tax basis. To achieve this goal, careful consideration of where and how you invest your funds is important. Some investments deliver most of their returns in the form of distributions or income which are taxed each year. To maximise returns, it is advisable, all else being equal, to favour investments that generate a higher proportion of capital growth. This approach allows you to benefit from compounding capital growth allowing you to at least defer or even avoid CGT liabilities.
The table below provides a few examples of common investment options, outlining the proportion of total returns delivered in the form of distributions and income over the past 10 years.
Of course, structuring investments solely for the purpose of minimising tax liabilities is not advisable. Instead, I share this information for two reasons.
Firstly, many Australians with self-directed super (SMSF or wrap) tend to invest most of their funds in the ASX, resulting in an insufficient exposure to international markets. This not only means missing out on appealing investment opportunities but also overlooks the advantage of international shares, which often deliver more capital growth and less income compared to the Australian market.
Secondly, there is a growing popularity of diversified ETFs. These ETFs offer two key benefits. Firstly, they enable you to access various sub-asset-classes in a single investment, such as Australian and international shares, bonds, emerging markets, and more. Secondly, the professional management of asset allocation is handled by the product provider, determining how much to invest in each sub-asset class. The drawback, however, is that these investments generate most of their return in the form of income, which can be tax-inefficient.
When direct investment options suit
Whilst pooled superannuation options have their drawbacks, the top industry funds have delivered strong double-digit returns over the past decade despite their tax inefficacy, as I’ve recently discussed here.
However, pooled super options become less appealing for members with high balances for two primary reasons.
Firstly, industry super funds typically impose percentage-based fees ranging from 0.6% to 0.8% per annum. These fees start to really add up for people with high balances e.g., $6k to $8k p.a. on a balance of $1 million. Secondly, as balances increase, the impact of taxation treatment and outcomes becomes more substantial.
In general, individuals with a balance exceeding $500,000 would be wise to explore the use of a direct investment option for their superannuation investments.
