26 – Borrowing to pay super contributions
A great retirement strategy
Self-employed clients can consider whether their super contributions ought to be paid by debt. The contribution cap for the 2015/16 financial year for clients aged 50 and over is $35,000. For clients under 50 the cap is $30,000. If cash flow is a problem consider gearing the contributions. This has always been a relevant strategy but becomes even more so as a person approaches 60 as 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 debt taken on to finance the contributions. A 59 year old client can borrow in one year, make the contributions and achieve an immediate tax benefit, and then withdraw from the super fund in the second year to retire the debt.
This strategy boils down to tax deductible debt reduction, and can be a powerful strategy, particularly for those who have left super planning a little late.
For example, a financial planner using a practice trust to run her business can have the trustee borrow to pay a $35,000 deductible employer contribution, pick up a tax break each year and then pay the benefits out, tax free, at age 60 to retire the original borrowing.
Trusts facilitate such strategies because, unlike companies, there is no rule against loan accounts from trustees to beneficiaries. This means a trust can borrow to pay a large deductible super contribution of, say $30,000, and then remit an equal amount, i.e. the $30,000 cash generated by the business, to the owner without triggering a tax charge.
The strategy does not work for a business being operated via a company: the loan to the owner would be treated as an un-frankable dividend in the owner’s hands, which creates an effective total tax charge of more than 60%.
The idea looks like this.
Borrowing to pay deductible contributions is primarily an investment strategy. Borrowing to invest is a sound idea, when done prudently. 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 is greater than the cost of borrowing.
Ultimately you have borrowed to buy shares. This is fundamentally a good move. But running it through a concessional contribution strategy means you pick up an extra super/tax driven return. This makes the investment strategy sing, and significantly reduces risk.
Only employer contributions can be geared
Interest incurred by an employer to pay concessional contributions for employees is deductible under the general deduction rules.
But interest incurred in connection with non-concessional contributions or personal contributions is not deductible.
The client’s best interests
Any one with any business experience knows that a growing business will usually be chronically starved of cash. The owners’ private affairs are usually chronically starved of cash too. They may be in or approaching their peak cost years, with home loans, family holidays and school fees to pay. The growing business sucks up capital and the growing family sucks up most of what is left. $10,000 of super before 30 June is pushing it. Two lots of $30,000 in concessional contributions out of cash flow before 30 June is a pipe dream.
The solution? Borrow $60,000, and enjoy a net tax break of $15,000 ie $60,000 less (40% less 15%). That’s $15,000 cash net, and $25,000 in the business’ hands . And keep your cash for your private affairs. This is discussed in more detail in Financing your practice and Tax deductible debt. Never forget the ASX Russell Long Term Investing Report tells us both Australian shares and Australian property have averaged more than 9% a year over the last 20 years. This makes the strategy fundamentally commercial.
Ultimately this is a form of debt recycling and you can read more about this concept here: Mortgage Choice on debt recycling.
You may be concerned about how you will ever pay off that ever growing debt. Well, first, remember, its matched by ever growing super. And in the normal course of events the extra super will be more than enough to pay off the extra loan, plus leave a lot over. But each case is different and the issue needs to be considered and reconsidered regularly as part of your own financial planning.