There's no getting away from the fact that it's been a gruelling year for everybody, with advisers of SMSFs no exception. But, while no client likes to be reminded that their retirement savings have dropped by 30 per cent or so, there are some silver linings to this cloud. We look at some strategies that can help the soften blow of the downturn - or even make a virtue of the falls in asset value.
Losses and gains
If anything characterises this downturn as particularly painful, it's the fact that so few assets seem to have been immune from the negative investor sentiment. Property, whether commercial or residential, has suffered in many areas as badly as share prices. There are no sharemarket safe havens anywhere across the globe, and many debt investments have been dragged down by the sub-prime debacle.
As the common wisdom goes, falls in asset value are only a problem if you have to cash in and crystallise the losses. But in some cases, crystallising a loss can be a good long-term strategic move.
For those who own shares in their own name for instance and have been holding off transferring them into their SMSF for fear of a huge capital gains tax bill, the downturn has created an opportune time to do so, says HLB Mann Judd Sydney head of wealth management Michael Hutton.
"Yes it's a shame the share portfolio may have fallen, but it does mean members won't be incurring huge capital gains when they transfer the shares into their SMSF," he says. Having shifted shares and other assets into the SMSF, when a bounce back does eventually happen, the gains will occur within a lower tax environment, he points out.
Such a transfer can be carried out either via an off-market transfer or by cashing in the shares and making a contribution into the SMSF with the cash, with the intention of repurchasing the shares from within the SMSF. The Australian Taxation Office has explicitly prohibited "wash sales" - the selling of assets purely to incur a capital loss if it is with the intention of buying them back again. However, Hutton points out, in this case the intention is not so much to crystallise a capital loss as to build up the trustees' retirement wealth within their SMSF.
The same principles apply to business real property, says SMSF Strategies principal Amreeta Abbott. "A trustee may own a business property that has lost value in recent years or is able to use the CGT (capital gains tax) small business retirement exemption. The new borrowing rules for SMSFs provide them with the ideal opportunity to move property into their SMSF," she says.
Doing so not only crystallises the capital loss or CGT exemption, but also allows the trustee to set up a plan to pay the property off over the next few years with their super contributions.
Indeed, while any investment decision should never be taken purely for tax reasons, any decision to buy and sell an investment needs to be made taking the tax consequences into account, says Professional Super Advisers director Kevin Smith.
"You need to understand the tax liability that is associated with the sale of any asset, and take that into account," Smith says. "Often it's about the timing - or perhaps more a matter of ensuring you don't time it incorrectly."
While capital losses can be held over to offset future capital gains, a realised capital gain cannot be offset by losses realised in later financial years, Smith points out. That makes it essential to ensure that any decisions to sell assets at a loss are made in the same financial year as assets sold at a profit, he says. Take a trustee who wanted to sell CBA shares that they have held for some time and that now show a significant capital gain. The trustee also has Telstra shares that have fallen in value and are wondering whether to cash them in. "If they were to sell the CBA shares in June 2009 and the Telstra shares on 1 July 2009, then the tax loss on the Telstra shares would not be offset against the CBA gain as they were realised in the subsequent tax year," Smith points out.
As well, there is no benefit in waiting until after 1 July to sell loss-making shares for anyone looking to switch into pension phase in the 2009/10 financial year, Smith says. "If the fund were turned into a pension fund on 1 July 2009, then it is likely that the losses would never be utilised," he says.
Those who have dual accounts with funds segregated between pension and accumulation accounts, a common case for those with a transition to retirement pension, also need to think about which of the account loss-making assets should be held, Abbott points out. "In times like this for instance, you would do well to shift loss making assets to the accumulation account," she says. "Then if you decide to sell them you can at least use those losses to offset any gains within that part of the fund."
On the other hand, assets showing strong gains or income should be moved to the pension phase where they will not be subject to any tax and will provide the desired income for the member.
Maximise tax-free components
Another strategy that makes the best of a bad situation is the use of proportioning rules to increase a member's tax-free component. The tax-free component is defined as the member's crystallised segment plus his or her contributions segment, says Heffron Consulting principal Meg Heffron. The taxable component is "everything else."
The tax-free component is set as a dollar figure in the accumulation phase of a fund - and remains at that figure whether the balance falls or rises. For those who made large un-deducted contributions of up to $1 million leading up to 30 June 2007, it is a situation that can be vividly demonstrated by the probability that their $1 million may have shrunk by as much as 30 per cent, to say, $700,000.
The silver lining however, as Heffron points out, is that the member is still entitled to their original tax-free amount if and when their balance increases again. This creates the opportunity for the member to, in effect, convert superannuation that would normally fall into the taxable component (say new employer contributions) into a tax-free amount.
"It is especially interesting if a member is wanting to consolidate two funds," Heffron says.
In this case, the choice of which fund should be rolled into which becomes of prime importance. For instance, if a member whose fund balance had fallen from $1 million to $700,000 rolled that amount over into another fund containing $300,000 (all of which was a taxable component), they would lose the opportunity to boost their tax-free component back to $1 million. "The act of rolling it over would lock in the lower $700,000 amount," Heffron says.
However, by reversing the direction of the rollover, and instead transferring the smaller (all taxable) fund into the larger fund, the combined amount of $1 million would all be tax free. This is because the new rollover simply boosts the overall balance back to the original $1 million tax-free amount. "It's really about going through the right order of events," she says.
The same goes for any new contributions made into the fund containing the tax-free component, Heffron adds. These, along with any future earnings, will become tax-free until the original tax-free balance has been reached. For those who have already switched into pension phase, it is a different story, says Heffron. The tax-free component is expressed as a percentage when a pension starts and that percentage is set in stone for the life of the pension. For instance, if the tax-free component was $700,000 (shrunk down from an original $1 million) and a trustee converted the fund into a pension, that pension would be 100 per cent tax free. "However, new taxable contributions (say $300,000 over several years) would stay in a taxable component - they cannot claw back the $300,000 tax-free component as they could in accumulation phase."
"In an ideal world, we would be in pension phase during a rising market (so that the tax-free component rises in line with the overall balance) but accumulation phase during a falling market to maximise our tax-free component," Heffron says.
Of course the issue of maximising the tax-free component is of most interest for those who plan to retire before the age of 60, in which case income from any taxable component will be taxed at the rate of 15 per cent. Also, if a member plans to leave money to a financial beneficiary, those beneficiaries will also be taxed at the 15 per cent tax rate. However, Heffron says even for those who don't fall into either of these categories it is still worthwhile maximising the tax-free component while the opportunity is there.
Indeed, it may be foolhardy to presume that the current tax-free regime for pension incomes taken after the condition of release is fulfilled is set in stone. Indeed, as Smith points out, legislative change is an ever-present possibility that needs to be taken into account.
"It certainly makes sense to maximise tax-free components in order to protect yourself against any potential changes to the tax rules in the future."
Take advantage of imputation credits
The extent of the downturn may have made it difficult to encourage clients to make any further forays into the sharemarket in fear of further volatility, but Michael Hutton says the fall in share prices of even the bluest of blue chips has boosted dividend yields to their highest levels in years.
Add to that the value of the imputation credits attached to dividends received within SMSFs, especially those in pension phase, and Hutton says it's a compelling story. "When dividends are received within the pension phase of an SMSF, not only do trustees not have to pay tax on them, they actually get a refund cheque from the government for the imputation credits attached to those dividends," he says. "Imputation is a dead set cash refund - no strings attached." This has been the case for many years, Hutton acknowledges, but with the downturn dragging down share prices and boosting dividend yields on even the bluest chip shares, it's a much more powerful story than it was two years ago, he says. "Yes, companies will have to cut dividends - ANZ for instance has cut dividends by 25 per cent. But even if yields were down to 6 per cent, imputation credits add another 2.5 per cent to that yield - taking you up to an 8.5 per cent income return - after tax."
On a $1 million share portfolio, that's an $85,000 yield, Hutton points out. Yes there's the small matter of share market volatility, and there's certainly no guarantee we've seen the bottom of the sharemarket bloodbath yet. "But if you try to ignore the share price movements in the short term and look at it in five- to ten-year terms, that is an amazing yield," Hutton says .
Even in pension mode you've got to be thinking of the long term, he points out.
Strategies to soften the downturn
- Take advantage of fallen asset values, and thus smaller capital gains tax bills, to transfer shares and other assets into SMSF portfolios,
- Use new borrowing rules to transfer business real property into an SMSF,
- Time sell-ups to ensure capital gains can be offset by capital losses,
- For dual account funds, shift loss-making assets into an accumulation account,
- Convert taxable amounts by rolling them into funds with fallen tax-free components,
- Buy blue-chip shares to take advantage of historically high dividend yields plus franking credits.
