Money: A super way to trim tax bills

A tax incentive for saving - a species long thought extinct - has been rediscovered amid recent changes to the tax system.

As a result, superannuation schemes can now offer a useful tax bonus.

Only those earning $60,000-plus need apply, and the new rules are not exactly a free ticket to riches, but they do allow you to use a super scheme to make a handy dent in your tax bill.

To see why, flash back to April 1 this year, when the Government made good on its election promise to raise the top tax rate from 33 per cent to 39 per cent on incomes over $60,000.

What it didn't do at the same time was change the tax on employer contributions to super schemes, which stayed at 33 per cent.

Anyone earning over $60,000 now had an incentive to get as much as possible of that income paid in the form of super contributions - taxed at 33 per cent - rather than wages or salary - taxed at 39 per cent.

Not surprisingly, the Government was afraid that the 6 per cent difference between the rates would encourage top earners to steer a large portion of their income into super, then withdraw it soon after - effectively using the schemes as short-term bank accounts and trimming their tax.

The compellingly named Taxation (FBT, SSCWT and Remedial Matters) Act has now made it unattractive to use super schemes in quite such a naked way, but the incentive - or "loophole" if you prefer - is still there.

To prevent abuse, the Government decided to impose a new 5 per cent penalty tax on some withdrawals from super schemes which would - more or less - cancel out any tax advantage.

But the rules governing that penalty are so generous that super schemes can still be used as part of a tax-reduction strategy.

That strategy, often called "salary sacrifice," works like this. First, convince your employer to put some or all of your income over $60,000 into a super scheme rather than paying it directly to you as wages or salary. It does not have to be a company scheme - any registered super scheme will do.

If you are already contributing to a scheme out of your after-tax income, try to persuade your employer to make those contributions on your behalf, rather than paying the money to you as income.

Money going into the scheme will be taxed at 33 per cent, rather than the 39 per cent you pay if you receive it directly. Your contributions can then build up and you will eventually be able to withdraw them, along with any investment earnings. When you do, your chances of incurring the 5 per cent penalty range from slight to nil.

PricewaterhouseCoopers calls that "a significant tax incentive for employees to save for retirement." How significant? An example from Tower Managed Funds compares two investors - call them Fred and Jill - each earning $80,000 before tax. Fred's employer puts $8000 into a super scheme and pays out the other $72,000, giving Fred an after-tax income of $52,650.

Jill, on the other hand, takes all $80,000 as salary, receiving $57,530 after tax, and makes her own super contributions.

Assuming both are happy to live on the same after-tax income - $52,650 - Jill has $4880 to invest in super. That is less than the $5360 going into Fred's scheme - $8000 of employer contributions minus 33 per cent.

After 20 years, assuming annual returns of 5 per cent, Fred and Jill have enjoyed the same after-tax income, but he has $182,000 in his scheme, compared with her $165,700.

So what happened to the 5 per cent penalty? If Fred keeps his money in the super scheme until he leaves his employer, the penalty does not apply.

The legislation also includes a long list of other circumstances in which there will be no penalty (see "New penalty regime," below). In fact, that list is so long that it's hard to imagine anyone ever having to pay the 5 per cent charge.

The irony of all this is that the incentive, which resulted from the Government's desire to tax higher incomes more heavily, is available only to the relatively well-off; people earning less than $60,000 cannot use superannuation to cut their tax bill.

While paying less tax has an undoubted appeal, it is not the only thing to consider when deciding on an investment strategy, especially when Governments candecide to change the rules overnight.

If you have a mortgage, for example, you may be better to concentrate on paying it off, rather than putting money into super.

Lawyers Chapman Tripp point out that it would be a brave person who set up a super scheme simply to take advantage of a tax benefit like this.

But, says the firm, "If employees earning over $60,000 have access to an employer-sponsored superannuation scheme, then they should consider having as much of their earnings as possible paid to the scheme as employer contributions - particularly if they do not have a more effective use for the money (such as paying off a mortgage) or the self-discipline to embark on an investment programme and in a way that avoids classification as a trader."

Before you can take advantage of this incentive, you also need to be in a position to lock away part of your income; there is not much point chasing a tax incentive if you already need everything you earn to pay day-to-day expenses.

Remember, too, that not all super schemes are created equal. Don't forget to ask about things like fees and the investment strategy just as carefully as you would if there was no tax incentive.

* To contact personal finance editor Mark Fryer, write to: Weekend Business, PO Box 32, Auckland. Ph (09) 373-6400 ext 8833 Fax: (09) 373-6423 e-mail: mark_fryer@herald.co.nz