Borrowing to invest in superannuation

Borrowing to invest in superannuation is a strategy that has, up to now, not quite stacked up as a personal finance strategy.

This is because while borrowing to invest in shares or property is tax-deductible, borrowing to invest in superannuation is not. However, three important elements have combined to put the strategy firmly on the agenda as one to consider.

Firstly, record low interest rates mean that even without a tax deduction, borrowing is cheap. Secondly, employed people can now make personal contributions to superannuation and claim a tax deduction. Thirdly, the $25,000 annual limit for tax-deductible superannuation contributions reduces the ability to get large sums of money into the superannuation just prior to retirement – meaning people may want to start contributing earlier with borrowed money.

Given our proximity to the end of the financial year, when superannuation contributions are considered as part of the end of year tax planning, now is an interesting time to ponder whether borrowing some money and making a tax-deductible superannuation contribution before the end of the financial year is a personal finance strategy worth pursuing.

A case study – borrowing to invest in superannuation

Let’s consider how these three elements; low interest rates, tax-deductible superannuation contributions and caps on superannuation contributions, work together by considering someone five years from retirement.

Let’s assume they are earning a slightly above average income of $100,000, they will receive compulsory employer contributions of $9,500 per year, leaving them a potential $15,500 of additional contributions before they reach their concessional contributions cap and consider how the strategy might work for them.

The first benefit from the borrowing and making a tax-deductible contribution to superannuation strategy is that a $15,500 tax-deductible contribution to superannuation reduces taxable income.

For a person on a $100,000 income, their marginal tax rate is 32.5 per cent, and a tax-deductible contribution of $15,500 generates a tax refund of $5,040.

Let’s now consider the interest costs of the borrowing.

We will assume that we use the $5,040 tax refund to immediately pay down the loan, leaving us with a $10,460 loan over the five years.

Banks are currently advertising a 2.25 per cent per annum five year fixed loan, so let’s use that as the interest rate over the next five years, $235 of interest per year or $1,175 in interest paid over the five year period.

As the $15,500 is contributed to superannuation, it is subject to a 15 per cent contributions tax. This amounts to $2,325. After the superannuation contributions tax is paid, we have $13,175 sitting in our superannuation fund.

An important but uncertain element to our calculation is, what is the investment return in superannuation over the five years? This can make or break the strategy – a positive return and we will be well ahead, a negative return and we can easily be behind.

Let’s assume a fairly conservative investment strategy, and a return of 5 per cent per annum over the five years.

In five years’ time, the balance of the initial $13,175 investment will be $16,815. After paying out the $10,460 loan and the $1,175 in interest, the total profit from the strategy will be $5,180.

By itself, this might not be a huge boost to a final superannuation balance, but over a number of years, it has the potential to make a positive difference.

The ‘superannuation balance boost’ will be improved even more if you have excess income toward retirement and can pay the loan off without withdrawing any money from superannuation at retirement – leaving the whole balance in your superannuation account to help fund a retirement income.

The risks

This strategy is not risk-free, and there are three key risks to be aware of.

The first is around borrowing costs. In the case study we looked at, the five year borrowing cost is assured because it is a fixed rate loan. However, if a variable rate loan is used, then a sharp increase in interest costs will reduce the effectiveness of the strategy. Similarly, if a fixed loan is used that doesn’t cover the whole period leading up to retirement, the strategy may be exposed to higher borrowing costs when the fixed period ends.

Secondly, there is the assumption of investment returns. Over a relatively short period of five years, there is the potential for a wide range of investment outcomes, and lower or even negative returns are absolutely possible.

Thirdly, there is legislative risk – the chance that the superannuation rules might change. For example, there is a chance that a person relying on paying off the loan with a lump sum withdrawal from superannuation at retirement might face a change in withdrawal rules. For example, a new tax on any lump sum withdrawals from superannuation would decrease the effectiveness of this strategy.

Conclusion

Borrowing to invest in superannuation has generally not been a mainstream personal finance strategy. Currently, however, there are a unique set of circumstances that now make it a strategy worth considering.

If a tax-deductible superannuation contribution is made to superannuation using borrowed money, the historically low rate of interest means that the numbers do start to work, even without the interest from the loan being tax-deductible.

The numbers used in the case study suggest that borrowing $10,460 to fund a $15,500 tax-deductible contribution to superannuation, with the balance funded by the $5,040 tax benefit, led to a profit of just over $5,000 in five years assuming a 5 per cent per annum superannuation fund earning rate.

The other borrowing option worth considering is a non-concessional contribution using borrowed money. In this case, the calculation is a little more simple.

There is no tax concession on the borrowed money or tax payable on the contribution, so it is a race between the superannuation fund earnings and the interest cost of the strategy as to whether you end up ahead or not.