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2. Why McMasters’ Recommends Borrowing to Pay Deductible Contributions

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 $31,000 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 borrowing². 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.

Case study: Dr Happily Married and Mrs Sadly Married

Happily generates a net income of about $200,000 a year from his practice, after all deductions other than superannuation.

This is actually a very high income relative to the general population. But after being taxed at up to 46.5%, including Medicare, and paying three lots of Kings College school fees at about $20,000 a time there is not a huge amount left over for Happily, Sadly and the three Married children.

Person	"Before" Income	"Before" Tax	"After" Income	"After" Tax
Happily	$200,000	$69,600	$35,000	$5,850
Sadly	Nil	Nil	$15,000	$2,850
Happily's super	Nil	Nil	$50,000	$7,500
Sadly's super	Nil	Nil	$100,000	$15,000
Family tax benefit	Nil	Nil		($8000)
Total	$200,000	$69,600	$200,000	$23,200
Tax percentage		31.8%		11.6%
Available Cash		$136,650		$199,300

Large geared deductible contributions worked a treat here. Happily and Sadly’s home is worth about $2,000,000 and has only a $600,000 mortgage. They have plenty of borrowing ability. Happily arranged for the Married PSI Medical Trust to pay Sadly a salary for the work she does, and to borrow $150,000 before 30 June 2007 and pay this amount as deductible contributions to the Married Superannuation Fund (which then, regular readers will not be surprised to hear, invested in Vanguard Index Australian Shares Fund⁶). The amount Happily and Sadly may contribute fell to $50,000 and $25,000 respectively on 1 July 2009.

This is a radical change in the Married’s financial position:

net tax payments reduced by $40,150 from $63,350 to $23,200; and
available cash for family living increased by $62,650 from $136,650 (ie $200,000 less $63,350) to $199,300 [ie $200,000, less ($5,850 plus $2,850) less $8,000]. The extra cash of $62,650, basically covers the school fees (ie 3 times $20,000 plus extras).