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As the retirement day of reckoning looms, it’s common for Australians of a certain age to regret not putting more into their super earlier on.
A tightening of super contribution limits in recent years means it’s no longer possible to pump up your retirement savings at the last minute. The longer you leave it, the harder it is to get big licks of cash into super. Conversely, the sooner you start the better. Why?
Tax efficiency and compound interest, it’s that simple.
The power of compound interest
You have probably heard that Albert Einstein described compound interest as the eighth wonder of the world. Thankfully, you don’t have to be a genius to take advantage of it.
Compound interest means you earn interest on your interest. The longer this compounding continues, the bigger your savings will be.
In the context of super, your money is locked away for upwards of four decades until you retire. During that time, all investment earnings on your savings is reinvested.
Tax-efficient savings vehicle
Concessional (before tax) contributions into super are taxed at just 15% on the way in. That includes your employer’s Super Guarantee (SG) payments, salary sacrifice arrangements and tax-deductible personal contributions, up to an annual limit of $25,000.
Because concessional contributions are made before tax, they provide significant tax savings for higher income earners. Instead of paying income tax at a marginal rate of up to 45% you pay contributions tax of just 15%, or 30% if you earn more than $250,000 a year.
However, making extra super contributions is generally tax effective if you earn more than $37,000 a year.
If you have reached your $25,000 annual concessional contributions limit, you can also make a non-concessional (after-tax) contribution. You won’t pay the 15% contributions tax, but there is an annual concessional contribution limit of $100,000 or up to $300,000 in any three-year period. Why would you bother when you could simply invest the money outside super?
Two reasons, tax and compounding. Once your money is inside your super fund you pay tax on investment earnings at a rate of up to 15%. If you bought the same investments outside super, you would pay tax on investment earnings at your marginal income tax rate. This leaves more money in your super fund to go on compounding.
But wait, there’s more. The biggest tax savings are left till last.
Tax-free retirement income
When you retire and start a super pension, you generally pay no tax on pension income or investment earnings inside your pension account from age 60. If you retire before 60, there may be some tax to pay.
As with everything to do with super, there are rules. To move from the accumulation phase of super to retirement phase, you must retire and satisfy a condition of release or turn 65. And once you start a super pension you must make minimum annual withdrawals.
There are also limits to the government’s generosity.
Keeping a lid on super savings
It’s important to recognise that the sole purpose of super is to provide retirement benefits for members, not to act as a lightly taxed store of intergenerational wealth.
With this purpose in mind, the government conducts a fine balancing act. While encouraging us to save for our retirement with generous tax concessions, it also caps the amount we can have in super and still enjoy those tax benefits.
Your total superannuation balance (accumulation and pension accounts combined) cannot exceed $1.6 million if you want to remain eligible for certain tax concessions.
Just to confuse matters, there is also a $1.6 million transfer balance cap on the amount of money you can shift from accumulation phase to retirement phase.
What about lower earners?
While super tax concessions undoubtedly favour wealthier individuals, there are also incentives for lower income earners to add to their retirement savings.
If you earn $38,564 or less, the government will contribute 50c for every dollar of personal contributions you make into your super account, up to a maximum of $500. That’s a return of 50% on your investment which is close to impossible to match, legally at least.
The government co-contribution phases out once your income reaches the upper threshold of $53,564.
While an additional super contribution of a thousand or two a year might seem like small beer, it can make an enormous difference to your retirement super balance.
Go early, go super
To paraphrase then Treasury Secretary Ken Henry’s advice to government during the GFC, to maximise your retirement savings while allowing tax and compound interest to do the heavy lifting, the best approach is to go early, go super.
Not only does adding to your super earlier in your working life make the most of compounding, but it also means you won’t run up against contribution limits later in life as you scramble to give your super a last-minute boost.
Case study one: Getting rich slowly
To illustrate a get-rich-slowly approach, take the hypothetical example of a 30-year-old earning $100,000, with a current super balance of $50,000. Let’s call her Jess.
Using the government’s Moneysmart retirement planner calculator, we estimate that if she relies on her employer’s SG payments and makes no additional contributions, she can expect a final retirement balance of $648,445 at age 67. This would provide annual retirement income of $44,332 up to age 90. (Note: Use the link to the calculator above to check the assumptions used for cost of living increases and investment returns. You can alter these to suit.)
Age 30, salary $100,000, super balance $50,000, retire at 67
|SG only||$5,000 / yr extra||Increase|
|Annual retirement income||$44,332||$52,738||$8,406|
If Jess were to make a personal tax-deductible contribution of $5,000 a year until she retires, she would end up with a final balance of $885,403 ($236,958 extra) and annual retirement income of $52,738 ($8,406 extra). A welcome gain for minimal pain.
To put this in perspective, the ASFA Retirement Standard estimates that to live comfortably in retirement a single person would need annual income of $44,183. To generate this level of income they would need a retirement balance of $545,000.
While Jess just meets ASFA’s comfortable standard on SG payments alone, retirement income of $44,332 might be a lifestyle shock for someone used to earning around $75,500 after tax ($100,000 before tax).
A better guide might be the 70% rule of thumb, which estimates the amount of retirement income you should aim for is around 70% of pre-retirement income (after tax and super). This suggests Jess could continue to enjoy her usual lifestyle on retirement income of $52,852 a year (70% of $75,503). Coincidentally, this is close to the level of income she could expect by contributing an extra $5,000 a year to super during her working life.
Case study two: Making up for lost time
It’s often not until you hit your 50s that saving for retirement becomes a priority. By that stage, compounding has less time to weave its magic and there are limits to what you can contribute to super even if you have the cash. Even so, there is still a lot you can do to make up some lost ground.
Take the example of a 55-year-old with $400,000 in super and a salary of $100,00. Let’s call him David.
If David does nothing and relies on his employer’s SG payments alone, he stands to have a retirement super balance of $642,235 at age 67 and annual retirement income of $46,516. This puts him a bit ahead of ASFA’s definition of comfortable (annual retirement income of $44,183 and a retirement balance of $545,000), but probably short of his own expectations based on his pre-retirement income.
Age 55, salary $100,000, super balance $400,000, retire at 67
|SG only||$5,000 / yr extra||Increase||$15,000 / yr extra||Increase|
|Annual retirement income||$46,516||$48,278||$1,762||$51,981||$5,465|
If he contributes an additional $5,000 a year as Jess is doing, he won’t have a great deal more to show for it once he reaches age 67 (retirement income of $48,278 a year vs $46,516 on SG alone).
Instead he decides he can afford to make an annual concessional contribution of $15,000 which, combined with his employer’s SG payments of $9,500 a year, takes him close to the concessional contributions cap of $25,000 a year. This will make the most of super’s tax concessions and give him a handy tax deduction on his personal contribution.
The upshot is that his retirement balance should increase to $814,828 (up $172,593 compared with doing nothing). This should provide him with annual retirement income of around $51,981 (up $5,465), which is close to the $52,852 suggested by the 70% rule of thumb for someone on his level of pre-retirement income.
What’s interesting to note is that even though David personally contributes three times the amount that Jess does from age 55, he still ends up with less super.
Thanks to the twin benefits of compound interest and tax, even small amounts you contribute to super early in life will make a big difference to your retirement savings. That said, it’s better to start late than never.
To work out the value of different super contribution strategies for your personal circumstances, jump onto the Moneysmart retirement planner. Also check out SuperGuide’s Retirement calculators and reckoners.