Eliminate Tax on Investment Income – SMSF Borrowing Strategy

Superannuation is the most tax-effective vehicle for investment. Either taxed on earnings at 15 per cent, or for those funds that are paying pensions to their members, a superannuation fund’s earnings become tax free.

The problem however, is that the government knows all too well how concessionally taxed superannuation has become, so it has limited the amount that individuals can contribute to their concessionally taxed superannuation funds.

As a result, many people have significant investments outside of superannuation that are taxed a higher individual marginal tax rates. Clever investors hold their investments in trusts so that the income can be distributed effectively to different members of their families, or to a beneficiary company, where tax is capped at 30 per cent as long as the funds are retained by the company.

That has been one of the best strategies, until recently. There is now a new strategy available which will help those with Self-Managed Superannuation Funds (SMSF’s) minimise, or in many cases eliminate, income tax on investment earnings, thanks to government legislation that allows these funds to borrow.

This is how it can work: take the example of someone who has $2 million worth of investments outside of super. As is, their investments outside of their SMSF (assuming an investment return of six per cent) would be generating income of $120,000, with tax liabilities of up to $55,800 per annum.

Depending on their age and circumstances, it may be possible to make non-concessional contributions of up to $150,000 per year into the fund, or to ‘bring forward’ three years’ worth of contributions, to contribute $450,000 right now.

This strategy is great, but it still leaves more than $1.5 million outside of superannuation and up to $43,245 payable in tax. And the individual cannot contribute anything more to their fund, as excess –contributions tax can equate to an effective tax rate of up to 93.5 per cent.

But now let’s consider the possibility of lending additional money to the fund. Be warned, while borrowing in the world of an SMSF can be a highly effective strategy it is also highly complex and required careful planning and expert advice.

If the remaining $1.5 million was loaned to the fund, it could use the loan to purchase an investment. The income from that investment would then be earned by the fund and concessionally taxed as such. If all of the assets of the fund are being used to pay a pension – that is the fund is in “pension mode” – then the income of the fund is tax free. The result is no income tax or capital-gains tax being payable, and a tax savings of up to $55,800 per annum.

What’s the drawback? Why isn’t everyone doing it? Is it too good to be true?

Until recently, this strategy was not a poplar one, mostly due to advisors not being aware of the intricacies required to make the strategy so effective.

Also, many advisers think that borrowing in superannuation funds is limited to the acquisition of property – again, this is not the case. While the rules are complex, and the borrowings must be used to acquire a “single acquirable asset”, if the fund wants to use the borrowings to invest in a diversified portfolio such as cash, term deposits and listed securities etc., this can be achieved through the use of an appropriate structure.

This approach offers some major short-term savings for the canny investor, and is worth considering if you already have significant investments outside of superannuation, want to increase your investment in superannuation and minimise our tax liabilities.

Author David McKellar

David McKellar is a Chartered Accountant and Director of Allied Business Accountants, an accounting firm specialising in providing strategic advice and taxation services to business owners, investors and Self Managed Superannuation Funds.

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