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14. Borrowing to Pay Large Deductible Superannuation Contributions

It’s OK to say pay $50,000 to your SMSF before 30 June, or even in the case of a married couple who are both over age 50, $100,000. But where does the cash come from?

If cash flow is a problem consider gearing the contributions. This has always been a good strategy for doctors but it is now even better because there is no tax, or limit, on the amount of the lump sum benefit able to be taken out of the SMSF at age 60, or later, to retire the original debt. This strategy boils down to tax deductible debt reduction, and is a powerful strategy, particularly for those who have left super planning a little late. For example, a fifty-five year old GP using a PSI practice trust can borrow to pay a $100,000 deductible contribution to a SMSF, pick up a $33,000 tax break each year and then pay the benefits out, tax free, at age 60 to retire the original borrowing.

Practice trusts facilitate such strategies because, unlike companies, there is no rule against loan accounts from trustees to beneficiaries. This means a PSI practice trust can borrow to pay a large deductible super contribution of, say $100,000, and then remit an equal amount, ie the $100,000 cash generated by the practice, to the owner without triggering a tax charge.

The strategy does not work for a practice company: the loan to the owner doctor would be treated as an un-frankable dividend in the doctor’s hands, which creates an effective total tax charge of more than 60%. And the strategy does not work for an individual doctor (ie a doctor or dentist practicing in his or her own name) because interest on amounts borrowed to pay a self-employed person’s super contributions is not deductible (whereas interest on loans for employer contributions is deductible).

Diagrammatically speaking, it looks like this;

Diagram to go here

Borrowing to pay deductible contributions is first and foremost an investment strategy, and it’s an investment strategy we strongly recommend. This is because economic theory and economic history show that in the long run, on average, the rate of return on each of the major asset classes will be greater than the cost of borrowing. For example, the historical rate of return on Australian shares is now running at about 15% for each of the 30-year, 20-year and 10-year averages. Interest rates have averaged about 7% over these periods. This means, on average, investors who borrowed to acquire Australian shares have earned a net 8% per annum, compounding, over time.

The ATO View

For completeness, we note that the ATO accepts that a spouse who is an employee can be superannuated up to the deductible contribution limit, ie $25,000 under age 50 and $50,000 over age 50 (until 2012). This is so even where the amount is excessive relative to the market value of the work done by the employee spouse.

We usually recommend a three pronged approach, being:

ensure the spouse is a general law employee and actually completes an appropriate amount of real work for the practice, and pay the spouse a market salary for the this work, to help evidence the employment relationship;
arrange for the spouse to be appointed a director of a company; and
recording in minutes of directors’ meetings the fact that the spouse was under-rewarded in previous years.