For those of us who start a business at a relatiely early age, and work through the system until 65 and beyond, there stands a chance to accumulate up to 45 years’ worth of savings, give or take.
Throughout our working lives, Governments come and go, with elections at least every 3 years or so. There are always changes to the way we are governed and taxed, and adds the variable of political risk to our savings.
Whilst one can plan and implement risk mitigation strategies for investment, implementing strategies to level political risk is more challenging, by virtue of its unpredictability.
With the sheer size and value of wealth now sitting across superannuation funds in Australia, both sides of politics may succumb to the temptation to plug larger and larger gaps appearing in their respective annual budgets.
With each successive Federal Budget instalment, we should be bracing ourselves for unexpected changes. There will be winners and losers with any such changes; however, the Government's goal is to deliver wins in the longer term by necessity.
So, if all of your retirement savings are sitting in superannuation - over a lifetime, you are facing 45 years of potential investment volatility.
In the early years, superannuation is not as material, as your only savings usually come from compulsory employer contributions. However, towards the end of your working life, as you will have built up a superannuation nest egg over many years, this becomes substantive and crucial as you look to retiring.
For many, it is only later in their working lives that they can afford to seriously save for their retirement, after paying off their home and the costs of bringing up and educating their family start to abate.
Options Outside Superannuation – Private Investment Companies ('PIC')
Whilst effective retirement planning definitely includes contributing to superannuation, there are other options too.
Generally speaking, you may aim to own your own home, with the goal to pay it off as quickly as you can afford. Every dollar of interest you save gives you an effective after-tax saving on the principal you have paid off, and your principal place of residence is one of the last bastions of tax-free capital gain.
Before you start thinking about your next property, and looking into the intricacies of negative gearing, consider starting a Private Investment Company, or “PIC”.
In planning for financial independence, diversification is not just about your investment classes and geographies, but also your investment structures.
Having a PIC has the potential to provide a level of structural diversification to help mitigate against political risk. This is not suggesting it is better than superannuation, however many of the tax benefits are being whittled away by successive governments, and regulation is becoming more complex.
The Advantages of PIC’s:
PIC’s are not required to have an external administrator/be audited
SMSFs must be audited every year by an independent auditor, adding to the running cost. Whilst appointing an external administrator is optional for a SMSF, most SMSFs have one to help wade through the constantly changing complexities of government regulation and make sure they stay compliant.
There is no limit on contributions into a PIC as part of a personal savings plan
There are numerous limits on putting funds into SMSFs and this area alone has changed many times in recent years. At present, the limit generally is a contribution of $25,000 per beneficiary per year if you want to claim a tax deduction. However, your SMSF then pays 15% (and 30% if your income is more than $300,000). Currently you can also contribute an additional $540,000 per person within a 3-year period, however there is no tax deduction and no contributions tax.
You can withdraw funds at any time from a PIC
This is significant. Generally, once you put money into your Super fund, you can’t access it until you are over 55 and retire permanently from the workforce. And even if you qualify to withdraw funds, if you decide to take some funds out at 55, there can be tax consequences.
There is no requirement for a PIC to have a Trustee
Conversely, SMSFs are required to have either a corporate trustee, or alternatively each of the beneficiaries are required to be trustees. The obligations imposed by APRA and the ATO to understand and comply with the law are quite onerous. With any change to an investment or open a bank account, the administration requirements can become painful.
There is no restriction on the PIC borrowing from or lending to shareholders, subject to paying commercial interest rates
SMSFs are only allowed to borrow funds to purchase property under very strict rules. They are not permitted to borrow funds from or lend funds to related parties such as beneficiaries.
The income taxation regime for PIC's is relatively simple.
For SMSFs, contributions are taxed at 15%, income is taxed at 15%, and capital gains at 10%, so long as the fund is a complying fund.
Otherwise, contributions are taxed at the highest personal marginal tax rate. At first glance, it seems that SMSFs are better off, however there are limited opportunities to manage the taxable income for a SMSF, whereas a corporate can make prepayments, purchase depreciating assets, and/or make superannuation contributions in an effort to lower taxable income.
So, if you are a small business owner or professional with a discretionary trust, you can add a corporate beneficiary.
Example
If you allocate $100,000 to the corporate beneficiary in a given year, rather than pay tax yourself at the top marginal rate, the tax deferral is quite large.
The small corporate beneficiary (PIC) pays tax of 25.0% or $25,000.
On the highest tax rate, tax is 47% on the extra $100,000, or $47,000.
The top rate is 45%, plus the 2% Medicare levy. i.e. 47%
So, there is a deferral opportunity for the difference between 47% and 25%, i.e. 22%. Remember, this is a deferral and not a saving. However, as long as you use the funds within the company structure, you can use them for other investments over an extended period.
For professionals and small business operators, income can be diverted in this way. The amount can be varied each year subject to your other financial planning. There is no real upper or lower limits on how much income can be paid to the company. It is the diversion of this income at a preferable corporate tax rate that is the key.
When income tax is paid by the PIC, the franking account is credited. These franking credits can be used in the future.
There is the opportunity to get this tax paid back during years when shareholders have low taxable incomes.
For example, if a dividend of $12,740 is paid to a shareholder who has no other taxable income, this dividend is grossed up to $18,200, which is the amount of taxable income which attracts zero tax i.e. the tax-free threshold. The franking credits attached of $5,460 are then paid back as cash to the shareholder by the ATO.
At the upper end, you can pay an annual dividend of $100,000 to a single shareholder and pay no additional tax where there is no other income, as the franking credits cover the income tax otherwise payable.
When an SMSF pays tax, it is the same as paying income tax as an individual.
Income earned by the PIC can then be reinvested in listed securities which pay fully franked dividends
In this way, there will be no further income tax paid until the securities are sold at a profit. The franked dividends received each year will be essentially tax free and can be reinvested.
With advice, you can find investments that meet your needs and risk appetite. You determine when and how any funds are transferred out of the company and do this at a time that suits you, perhaps when you are receiving much lower levels of income. Refer to 7 above.
PIC Investments can offer asset protection
You can set up a PIC with the person least exposed to potential litigation as a director/shareholder. However, you need to remember that distributions of income can only be made to the shareholders.
The one big drawback of investing through a private company is that companies do not receive the 50% capital gains tax concession on the sale of assets. However, with the corporate tax rate at say 25%, and the top marginal rate at 47%, this disadvantage is not huge if you are on the top rate of personal tax.
PIC’s do not receive the CGT 50% concession, which is a reason that many advisors prefer the use of superannuation and discretionary trusts.
However, the use of a PIC can be a useful addition to your investment strategy and provides a number of benefits over other structures. It is worth considering along with superannuation and discretionary trusts.
More information?
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