Tax on Super Earnings After Retirement

For those unfamiliar, superannuation, commonly referred to as "super," is a mandatory system in countries like Australia, designed to ensure individuals have savings for retirement. Contributions are made during your working years, and the idea is to grow this fund through various investments. However, once you retire, the tax on the earnings of this superfund may continue depending on your age, balance, and how you choose to access your funds.

Let’s start with a common misconception: many retirees believe that once they retire, no taxes will apply to their superannuation funds or earnings. This isn't entirely true. While there are specific age thresholds and conditions where super earnings can be tax-free, certain earnings are still subject to tax—especially if your account exceeds certain limits.

Super Earnings: The Tax-Free Window

If you are 60 or older, your pension payments from a tax-free investment in your super account are, well, tax-free. However, that’s not the entire story. The earnings generated by your super, if taken as a lump sum or not correctly managed, might still attract taxes.

• Tax-free component: This part of your superannuation usually includes the contributions made after tax (non-concessional contributions) and possibly some rolled-over amounts. When you withdraw from this portion, no tax applies.
• Taxable component: The taxable portion usually includes employer contributions and any amounts on which a tax deduction was claimed. When accessed under certain conditions, this portion may still be subject to tax, depending on your age and the way the money is accessed.

The Retirement Income Stream vs. Lump Sum

Many retirees have the option to take out their superannuation either as a lump sum or as a pension income stream. The decision is pivotal because it determines the tax you pay.

• Pension income stream: Once you turn 60, any income stream drawn from your super is generally tax-free. This is an attractive option for many retirees who want a steady income without worrying about taxes.
• Lump sum withdrawals: Taking your super as a lump sum may attract taxes if you're below the age of 60 or if the amount exceeds specific limits. Generally, for those over 60, the lump sum is tax-free up to the low-rate cap ($235,000 for the 2023–2024 financial year).

Taxes on Super Earnings in Retirement

Once you start drawing from your super fund, the earnings generated within the fund—like interest, dividends, or capital gains—may still be taxed under certain conditions.

1. Accumulation phase: If part of your super is still in the accumulation phase (i.e., it’s still being invested and hasn’t been transferred into a pension account), the earnings will be taxed at 15%. This is significantly lower than the marginal tax rate but still something to consider.

2. Pension phase: If your superannuation is moved into the pension phase, the earnings from that account are generally tax-free. However, this tax-free status only applies if your pension balance is below the transfer balance cap (which is $1.9 million for the 2023–2024 financial year). Any excess over this cap must remain in the accumulation phase and will be taxed accordingly.

The Transfer Balance Cap

Introduced in July 2017, the transfer balance cap limits how much money can be transferred into the tax-free pension phase of superannuation. As of 2023, the cap sits at $1.9 million. If your total balance exceeds this cap, the excess amount must stay in the accumulation phase, where it continues to be taxed at 15% on its earnings.

This cap prevents individuals from stashing unlimited amounts into a tax-free environment while still allowing a substantial amount to grow tax-free once transferred into a pension account. Keep in mind that if you breach the cap, there are penalties, and you must withdraw the excess amount or return it to the accumulation phase.

Example of Taxes on Super Earnings

Let’s take the case of John, who retired at 65 with a superannuation balance of $2 million. He decided to move $1.9 million into the pension phase and left $100,000 in the accumulation phase. Here’s how the taxation works:

• Pension phase: John’s $1.9 million in the pension phase grows tax-free. All earnings from this portion of his super are tax-exempt.
• Accumulation phase: The $100,000 in the accumulation phase will have its earnings taxed at 15%. If John earns $5,000 from this portion, the tax payable would be $750 (i.e., 15% of $5,000).

Had John decided to withdraw all $2 million as a lump sum, he would have faced a potential tax liability depending on how much of his super balance was composed of the taxable component and whether he had already exhausted his low-rate cap.

What About Capital Gains Tax?

Superannuation funds are also subject to capital gains tax (CGT) on investments. However, the tax treatment varies depending on whether the fund is in the accumulation or pension phase.

• Accumulation phase: Capital gains from the sale of assets in this phase are taxed at 15%. However, if the asset was held for more than 12 months, the fund gets a one-third discount, reducing the effective tax rate to 10%.
• Pension phase: Capital gains from assets held in the pension phase are exempt from capital gains tax. This makes it extremely beneficial to shift assets into the pension phase before selling them, where possible.

Impacts of Legislative Changes

The taxation of superannuation earnings after retirement isn't set in stone, and governments often adjust these rules. For example, recent discussions around capping large superannuation balances at $3 million suggest that higher balances may soon face additional taxes beyond the current rules.

Keeping an eye on such legislative changes is crucial for retirees, especially those with substantial super balances. The government’s intent is to strike a balance between offering tax-advantaged savings for retirement while avoiding the creation of large, tax-free estates that could be passed down without paying taxes.

Managing Tax on Your Super: Strategies for Retirees

If you're approaching retirement or are already there, it's essential to work with a financial advisor to ensure that your superannuation earnings are being maximized in a tax-efficient manner. Here are a few strategies that can help you mitigate taxes on your super:

• Maximize your non-concessional contributions: Non-concessional contributions (made after tax) form part of the tax-free component of your super. By maximizing these contributions, you can increase the portion of your super that can be withdrawn tax-free in retirement.
• Consider re-contribution strategies: Retirees can withdraw super and re-contribute it as a non-concessional contribution. This strategy effectively converts the taxable portion of your super into a tax-free component, reducing the potential tax liability when you withdraw funds.
• Pension phase optimization: Ensure you move as much of your super as possible into the pension phase, up to the transfer balance cap, to benefit from the tax-free earnings environment.

Wrapping it All Up

While superannuation provides a fantastic vehicle for retirement savings, it's important to remember that taxes don't just disappear once you hit retirement. Understanding the nuances of how super earnings are taxed after retirement is key to making informed financial decisions. Managing the tax liabilities on your super is not only about following the rules; it’s about optimizing them for your unique situation.

Taxes on super earnings after retirement can be minimized with careful planning and strategic decisions. By understanding the transfer balance cap, making the most of pension phase benefits, and utilizing tax-effective strategies, retirees can ensure they are not paying more tax than necessary.