How super works: A beginner’s guide to superannuation

Simply put, superannuation (or super) is money you put in a super fund while you are working to provide income later in life when you retire. Given the average Australian can expect around 20 years of retirement, and the Age Pension is designed to provide only the most basic needs, the more you can save now the more comfortable and enjoyable your retirement years will be.

For most working age Australians, super is a right. If you are aged over 18, earn more than $450 a month and are regarded as an employee for tax purposes, your employer must pay money into a super account in your name, which is then managed by a super fund. This is called the Superannuation Guarantee (SG) and employers are legally bound to contribute 9.5% of your gross income, including bonuses, commissions and loadings.

You can also make voluntary, personal contributions to further boost your savings. For the self-employed, super is entirely voluntary.

How did we get here?

Super may seem like a part of the financial furniture, but it hasn’t always been that way. The introduction of compulsory super back in 1992 changed the savings and investment landscape in ways few could have imagined.

By June 2020, Australians had more than $2.7 trillion invested in super, making Australia the fourth largest holder of pension assets in the world. What was once a privilege restricted to managers, professionals and public servants now enjoys near universal coverage among employees, though coverage still lags for women and the self-employed.

Younger Australians will also have the benefit of higher employer contributions from the start of their working lives. The SG, originally set at 3%, rose to 9% in July 2002 and 9.5% in July 2014. The rate is due to increase by 0.5% a year from July 2021 until it reaches 12% in 2025/26.

This has done two things. For many people, super is their largest financial asset outside the family home, which ought to be a compelling reason to take more interest in it. The average account balance was $332,700 for men in 2017/18, and $245,100 for women, even though this age group has not enjoyed the benefit of compulsory super for their entire working life.

At the national level, it has created a pot of gold that attracts powerful vested interests and a temptation for successive federal governments to tinker with the rules.

To get the most out of your super, you need to keep your wits about you, but the benefits are worth it.

A win-win

Once your money is inside super, it is locked away for decades until you retire or reach another condition of release (see ‘When can I access my super’ below). That may seem overly restrictive, but it allows compound interest time to create a substantial nest egg.

The reward for your patience is that your super contributions and investment earnings inside super are taxed at concessional rates and you can generally withdraw your savings tax free in retirement. It is also a win for the government, as the more we all save for our own retirement the less it needs to spend on the Age Pension and other welfare benefits in the future.

Putting money in

If you are aged over 18, earn more than $450 a month and are regarded as an employee for tax purposes, then your employer must make SG payments to your super fund on your behalf. The SG is currently set at 9.5% of your gross income including bonuses, commissions and loadings but not overtime.

As always with super, there are exceptions:

• If you are under 18 you may still be eligible if you earn more than $450 a month and work at least 30 hours a week.
• Since 2013/14, people over 70 who are still employed are also eligible for the SG.
• The amount of SG that can be paid to high income earners is capped at an annual amount of $221,080 in 2019/20 and $228,360 in 2020/21.

In most cases, employees can choose their own super fund. There may be exceptions though: if a fund is specified by an industrial agreement, you are a member of a ‘defined benefit’ fund that meets certain conditions, or you work in the public sector.

Choosing a fund

For more information on how to compare and choose a fund or start your own self-managed super fund (SMSF), have a look at these SuperGuide sections.

• Choosing a fund
• SMSFs for beginners

When you choose a fund you also get to choose how your super is invested. Most big funds offer an investment menu of pre-mixed portfolios with varying risk/return profiles, ethical or sustainable options and the ability to invest directly in shares and other investments.

If you don’t choose a fund your employer will put you into a ‘default’ fund they choose for you. Your money will be invested in a MySuper account that has low fees and simple features.

Is the Superannuation Guarantee enough?

The compulsory nature of these employer-funded payments takes the pain out of saving for many Australians, but it can also encourage a sense of complacency. Super is often out of sight, out of mind, especially for younger workers who still have up to 40 years until retirement.

According to Grattan Institute modelling, most people today – whether they are already retired, still working or just entering the workforce ­– can expect annual retirement income of more than 70% of their pre-retirement income, the benchmark set by the OECD for a comfortable standard of living in retirement. In fact, some low-income workers stand to be better off in retirement due to a combination of the Age Pension and their super entitlements.

Of course, comfortable means different things to different people, so everyone needs to set their own retirement income target and work out how much super they will need to fund it.

The picture is not so rosy for people who entered the workforce before 1992, had time out of the workforce or who have been self-employed and not made regular super contributions equal to 9.5% of their gross income. If this is you, it’s likely you will need to make additional contributions to super to fund a comfortable standard of living in retirement.

The government tacitly acknowledges this retirement savings shortfall with tax concessions for voluntary contributions, but its generosity has limits. There are two contribution caps, based on whether you make contributions from before-tax or after-tax income.

Concessional (before-tax) contributions

Concessional contributions are amounts paid into your super fund on a pre-tax basis. The term ‘concessional’ is used because you pay contributions tax on money going in at the concessional rate of 15%, rather than paying tax at your marginal rate.

The maximum amount you can contribute at the concessional 15% rate is $25,000 a year. This includes employer contributions, salary sacrifice and any voluntary personal contributions for which you claim a tax deduction. If you split your pre-tax contributions with your spouse, they are still counted towards your concessional cap.

Under the new carry-forward rule, from 1 July 2018 you can carry forward unused concessional contributions for up to five years. This provides an opportunity for pre-retirees, or anyone who has taken time out of the workforce, to play catch-up and make additional super contributions at concessional rates. To take advantage of this new rule, your super balance must be under $500,000 on 30 June in the year before you make any additional contributions.

For example, say your concessional contributions in the 2018/19 financial year from all sources was $9,000, leaving you with $16,000 in unused concessional cap. In 2019/20 your contributions totalled $10,000, leaving you with a further $15,000 in used concessional cap. Your super balance as at 30 June 2020 is $220,000, so you are well below the $500,000 limit. In the 2020/21 financial year you could make concessional contributions of up to $56,000 (your annual concessional limit of $25,000 plus $16,000 plus $15,000 in unused cap carried forward from the previous two years). The first year the carry-forward rule could be used was the 2019/20 financial year.

Non-concessional (after-tax) contributions

Non-concessional contributions where no tax deduction is claimed are capped at $100,000 a year. This includes after-tax contributions made by you, your employer or your spouse. No contributions tax is paid on your money going in, but any excess contributions will be taxed at 47%.

You may be able to make additional contributions above the $100,000 annual cap under the bring-forward rule (not to be confused with the carry-forward rule mentioned earlier!). If you are under 65, you can contribute up to three times the annual non-concessional cap in a single year provided they don’t exceed $300,000 in any three-year period. (Legislation currently before Parliament, but not yet passed, would allow members under the age of 67 to use the bring-forward rule).

From 1 July 2020, if you’re aged under 67 you can make personal or non-concessional contributions into your super account without needing to meet the work test. If you are aged 67 to 74, you are generally restricted to annual after-tax contributions of $100,000, and then only if you work at least 40 hours during a consecutive 30-day period in the financial year the contribution is made.

However, from 1 July 2019 there is a new exemption from the work test for voluntary contributions in the first income year after retirement to allow retirees more time to prepare their finances. Currently, this means an individual aged under 65 will be able to make voluntary contributions of up to $300,000 using the bring-forward rule for one more year after they stop working. To be eligible, you must have had a total superannuation balance of less than $300,000 as at 30 June the previous financial year.

While some rules have been loosened, others have been tightened. From 1 July 2017 you cannot make any non-concessional contributions if your total super balance was $1.6 million or more as at June 30 the previous financial year.

Super housing measures

In the 2017 Federal Budget, two special measures were introduced to help ease the housing affordability crisis.

The First Home Saver Scheme (FHSS) allows you to make voluntary concessional or non-concessional contributions to your super to save towards buying your first home. Individuals can save up to $30,000 this way, so a couple could potentially save $60,000 in a tax-effective environment. There is quite a bit of red tape around this measure so be sure to read the fine print.

At the other end of the housing spectrum, if you are 65 or older you may be able to make a downsizer contribution to your super of up to $300,000 from the proceeds of selling your home. This is not a concessional or non-concessional contribution and does not count towards your contribution caps. However, it will count towards the $1.6 million transfer balance cap when you shift your super savings into retirement phase. In addition, it can only be used once, you must have owned the property for at least ten years, it is not tax deductible and it will count towards your eligibility for the Age Pension.

Growing your savings inside super

A friend recently told me she didn’t want to put extra cash into her super fund in case the sharemarket fell again. It’s a common misconception that super is an asset or investment class of its own that moves independently of other assets. It’s not.

A super fund is best imagined as a structure that holds your savings in a range of investments until you retire. You could hold the same portfolio of shares, property, bonds, cash and other investments inside a super fund or outside super in your own name or in some other structure such as a family trust. These investments, whatever the ownership structure, earn income in the form of dividends, rent or interest and produce capital gains or losses when they are sold.

The thing that sets super apart is its taxation status; despite constant government tinkering it is still the most tax-effective home for retirement savings. That and the length of time your savings are left to grow in super, generally produces a better return on your money in the long run than you would earn if you invested in comparable investments outside super.

Tax on investment earnings

Investment earnings inside your super fund are taxed at a maximum rate of 15%. If your fund holds Australian shares with franked dividends, then your fund will pay less than 15% tax on those earnings. So anyone on a marginal tax rate above 15% will pay less tax on their investment returns in super than they would if they held the same investments outside super.

Capital gains on the sale of assets inside super are also taxed at concessional rates. If the investment has been held for more than 12 months, the fund only pays tax on two-thirds of the capital gain at a rate of 15%. That’s an effective capital gains tax of 10% (two-thirds of 15%). If you held the same investment outside super for more than 12 months, you would pay tax at your marginal rate on half the capital gain, or up to 23.5% for people on the top marginal rate of 47% (including Medicare levy).

These are the tax rates that apply to investment returns inside super during accumulation phase. That is, while you are working and accumulating savings in super to be used in retirement.

Once you start withdrawing your savings as a lump sum, income stream or a mixture of both, your super is said to be in retirement phase, previously known as pension phase. You generally pay no tax on investment income or capital gains in retirement phase, but there are exceptions.

From 1 July 2017, investment returns on the assets underlying a transition to retirement (TTR) pension are taxed at 15%, just as they are in a super accumulation account. Previously they were tax free. However, these earnings are still exempt if you are over 65.

When can I access my super?

Generally, you need to wait until you retire. Super offers generous tax concessions in return for ‘preserving’ your nest egg until you reach a minimum age set by law and retire. The only exceptions are in cases of financial hardship, disability, terminal illness or death.

People who had money in super before 1999 may also have some ‘unrestricted non-preserved’ benefits which they can withdraw at any time.

Otherwise, your preservation age will depend on when you were born. For Australians born before 1 July 1960, preservation age was 55 but this is gradually increasing to 60 for younger age groups (see table below).

Preservation age

Source: ATO

Keep in mind that you need to be at least 60 for your super to be tax free.

Taking money out of super

When you reach your preservation age and retire you can withdraw your savings and accumulated earnings in a lump sum, as an income stream from a super pension, or a mix of the two. Withdrawals are usually tax free, but if you are younger than 60 there may be tax to pay.

If you are younger than your preservation age and withdraw a lump sum under the limited conditions of release described earlier, you will be taxed at 22% plus Medicare levy or your marginal rate, whichever is lower.

Before you can start taking money out of super, you need to transfer up to a maximum of $1.6 million (known as the transfer balance cap) into a pension account. Then you must withdraw a minimum amount each year based on your age and account balance (see table below). There is no maximum withdrawal amount, although most retirees tend to err on the side of caution for fear their money will run out.

Note: These minimum withdrawals rates have been temporarily halved for the 2019/20 and 2020/21 financial years so retirees are not forced to sell assets in the COVID-related market turmoil simply to meet their minimum pension payments. 

Minimum pension payment percentages by age

Source: SIS Act

The most common type of super pension is an account-based pension. However, if you reach your preservation age, are under 65 and still working you may be able to withdraw a portion of your super as a transition to retirement (TTR) pension. Income from a TTR pension is tax free if you are aged 60 or more. If you are younger than 60, income will be taxed at your marginal rate less a 15% tax offset.

If you have more than $1.6 million in super, you can leave the balance in your accumulation account or take it out of super entirely. You can keep an accumulation account open as long as you like, even if you have retired.

Once you start a super pension you can’t contribute more money to it unless you stop the pension (called a commutation) and start it again with additional savings up to a maximum pension account balance of $1.6 million.

If you reach preservation age, retire and withdraw your super as a lump sum before you turn 60, you may have to pay tax. The rules are complex so anyone contemplating early retirement should seek independent financial advice from a retirement expert.

What happens when you die?

If you die before all your super is withdrawn, your super fund pays a death benefit to your dependents, other nominated beneficiaries or your estate. Death benefits include the balance of your super account plus an insurance benefit if you have been paying life insurance premiums from within your fund.

You need to nominate who you want to receive your death benefits when you die. There are two types of nomination:

• A non-binding nomination acts as a guide to your fund’s trustees but it can be overturned in some circumstances.
• A binding nomination allows you to name your dependent or legal representative, usually the executor of your will, and stipulate that they receive your death benefits. Your legal representative then distributes the money according to your will. You need to renew a binding nomination every three years to remain valid and most funds charge a small fee.

Super death benefits are made up of taxable and tax-paid components. The amount of tax a beneficiary must pay depends on the component, whether they are a dependent for tax purposes and whether the super is taken as a lump sum or income stream.