Super vs Non-Super: A Balancing Act

A key tension in deciding a personal finance strategy for people in the wealth accumulation phase is around where to invest money – outside of superannuation where it is accessible or inside superannuation where there are distinct tax advantages?

This strategic decision has become a little more challenging in recent years, with the current concessional superannuation cap of $27,500 limiting the ability of people to make large tax-deductible contributions close to retirement (for example, running an aggressive salary sacrifice strategy close to retirement). Balanced against this is the ability of people to make personal contributions to superannuation and claim a tax deduction for them, giving people more flexibility in how they contribute their own money to superannuation.

The Super Investment Environment

The benefits of superannuation as an investment environment are generally well known. It provides an opportunity where contributions are taxed at 15 per cent rather than an individual’s income tax rate. It provides an environment where the earnings of the superannuation fund are taxed at a maximum of 15 per cent, and 10 per cent for concessional capital gains. In retirement, it allows a person (from the age of 60) to draw a tax-free income stream and allows the earnings of the superannuation fund paying the pension to be tax-free.

In short, it is a tax-effective way to build assets to fund retirement – and the variety of options for the superannuation fund, from low-cost industry funds through to self-managed super funds, allows a range of investment strategies and assets to be accessed in superannuation, depending on personal choice.

Having Money Outside Super

That said, superannuation has one significant downside – the inability for a person in their working years to access it, short of significant circumstances that might lead to a withdrawal on compassionate grounds.

Someone who might be 35 years old has a preservation age of 60, so has 25 years before they can access any money that they contribute to superannuation. If they decide to contribute more to superannuation they might save on tax but they are locking away the money for a quarter of a century.

Let’s start weighing the pros and cons of investing surplus funds either with superannuation or outside of superannuation.

Step 1 - Take the Free Money

Firstly, some employers run schemes that encourages extra superannuation contributions. For example, an employer might add an additional 5 per cent in superannuation contributions if an employee makes an additional contribution of 5 per cent. I would suggest that if there is ’free money’ in the form of additional employer contributions then that should be taken advantage of wherever you can. Even if you are just starting out in employment in your early 20s, money compounding in the tax-effective environment of superannuation over a long period of time is something you will appreciate as you get closer to retirement.

Step 2 - The Best of Both Worlds

It makes sense to first build some investment assets outside of superannuation, perhaps even up to the age of 45 or 50. A key goal over this time is often to pay off the mortgage and to be able to cater for any unexpected events. Using surplus income to build some assets that provide extra income, and access to money in the case of an emergency makes sense.

Of course, over this time compulsory superannuation contributions are being made to start building a superannuation balance, and at the current rate of 10.5 per cent, this is happening at a faster rate than ever before.

However, there comes a time when the balance shifts to thinking about building superannuation over the last 10 to 20 years of a working lifetime, balancing day to day surplus funds. This decision is often seen as an almost adversarial one; investing in the superannuation environment vs investing outside the superannuation environment.

There is a way to bring these ideas together over time. Rule changes came in during the 2018 financial year that allow a person to claim a tax deduction for a personal contribution even if they are employed. This allows income from a portfolio built outside of superannuation to be contributed to superannuation and a tax deduction claimed. Meantime, the franking credits received from the Australian share component of the investment portfolio are beneficial at tax time.

Step 3 – Crunching the Numbers

Let’s assume that Alice is 50 years old. As well as her diversified superannuation portfolio she has used her surplus income to build a $100,000 share portfolio outside of superannuation. She has largely paid off her home loan. Her focus now is on building her superannuation investments because she would like to retire at age 62.

The $100,000 share portfolio provides Alice with dividends of $4,500 per year and franking credits of $1,930.

Alice earns the average full-time wage (as measured by AWOTE – average weekly ordinary time earnings) of approximately $90,000 per year, so receives superannuation contributions of $9,450 per year. This is well below the annual threshold for tax-deductible superannuation contributions of $27,500 per year (2023 financial year), so Alice is able to make further contributions.

Currently Alice has gross income of $96,430 and pays $21,807 in income tax (excluding Medicare).

Previously, increasing superannuation balances close to retirement was often done through a salary sacrifice arrangement, and that remains a reasonable option. However, the recently introduced ability to make personal contributions to superannuation and claim a tax deduction allows Alice to use her dividends to contribute to superannuation, while making her financial situation more tax effective by claiming a tax-deduction for the contribution.

If Alice contributes the $4,500 as a tax-deductible superannuation contribution, she pays 15 per cent ($675) in superannuation contributions tax. However, her taxable income is now reduced to $91,930 and her income tax paid is $20,344, plus the superannuation contributions tax, a total of $21,019.

This is a total tax saving of around $800 per year – plus another $3,825 ends up in her superannuation balance.

Conclusion

The strategy of first building some assets outside of superannuation makes sense because it provides extra income over a working lifetime and access to funds in the case of an emergency.

However, the ability to make tax-deductible personal superannuation contributions allows the ’bringing together’ of outside and inside superannuation strategies – by using the income from an investment portfolio built outside of superannuation to make tax-deductible superannuation contributions. This has the duel positive impact of building superannuation and reducing a person’s total tax payable.