Clarifying tax offsets in retirement

Summary: In this article, we do all the calculations on how income tax is calculated along with the application of the Medicare Levy to come up with how imputation credits work with the Seniors and Pensioners Tax Offset.

Key take-out: Where the income tax credits exceed the tax and Medicare levy payable the individual receives a refund.

In a recent column, in which I answered a question relating to how much can be invested outside of superannuation after taking into account tax offsets, it appears that I have created more confusion instead of providing illumination.

Given that it is important that our subscribers understand how tax offsets work in relation to income earned personally, and how other things such as the Medicare levy and dividend imputation credits interact with income tax payable, I will be try to address the questions raised and clear the confusion I have caused.

Question: I had assumed that on a taxable income of $37,000, including franking credits of $3,000, franking credit offsets would be applied and then any SAPTO offsets. Could I just ask for clarification on the way franking credits work with SAPTO?  

Answer: To understand how income tax is payable by individuals, it is important to understand the order in which income tax is calculated and how the various offsets, Medicare Levy, and imputation credits, are applied.

The first step in the process of calculating how much income tax is payable is to calculate the taxable income for an individual. This amount will include all assessable income, plus dividend imputation credits relating to both direct share investments and managed investments, less all allowable deductions.

The next step will be to calculate, based on the individual marginal rates of tax, the amount of tax payable. From this tax payable amount is deducted all relevant tax offsets. In my column about how much people can earn outside of superannuation, the Low Income Tax Offset and the Seniors And Pensioners Tax Offset were taken into account.

Tax offsets cannot create a tax refund, so if the offsets are greater than the tax payable the net amount of income tax payable is zero. To the net amount of income tax payable is added the Medicare levy if it applies, to arrive at a total tax payable and Medicare levy amount.

The final step in the process is to deduct from the total of income tax and Medicare levy payable any income tax credits that apply. These would include Pay As You Go instalments and dividend imputation credits.

Where the income tax credits exceed the tax and Medicare levy payable the individual receives a refund. The main point of my previous column, about how much an individual can earn outside of superannuation, was to illustrate the point at which it did not make sense leaving all of the excess super over the $1.6 million pension transfer balance cap when an individual or a couple has no other taxable income outside of superannuation.

The following table shows the calculation of a tax refund for an individual that earns $37,000 including the $3000 franking credit, and how much refund each member of a couple with the same income would receive.

 *I take no responsibility or credit for the calculation of the Medicare levy as, due to the complexity of how it is calculated, I used the ATO's calculator shown on their website.

Question: It's not possible to work out the tax payable in respect of the $4,000 grossed-up dividend by assuming a 19 per cent marginal tax rate. That is because you also have to consider the SAPTO shade-out rate of 12.5 per cent and, above $34,244, the Medicare levy shade-in rate of 10 per cent.

Answer: I agree with your comment with regard to how the tax offsets and the Medicare levy affects how much someone can earn. The point of the amounts I had shown in my column was to show how much someone could earn and pay no income tax or Medicare levy, if they had investments outside of superannuation.

No Medicare levy is payable by individuals entitled to the SAPTO until their income exceeds $21,654, and the combined value of a couple's income exceeds $34,243. Once a person's income exceeds these Medicare levy thresholds it increases gradually until an individual is paying the full Medicare levy of 2 per cent, if the tax payer is eligible for SAPTO, until the income reaches $34,244.

Question: Have just read your article on "Maximising seniors tax offsets". Is the Seniors and Pensioners Tax Offset (SAPTO) only available for people on Centrelink benefits or is it also available for retired people with no Centrelink benefits?

Answer: Eligibility for SAPTO depends on someone having met the age condition to receive the age pension. It does not matter if they get the pension, they can be totally self-funded retirees, as long as they are of age pension age they are eligible to receive the SAPTO.