Tax-free super is intergenerational theft

A number of politicians have struggled this week to explain the Turnbull Government’s proposed changes to superannuation. Given the complexity of the area, that’s not surprising. And this complexity explains why intergenerational “theft” through superannuation has continued for so long.

Transition to retirement (TTR) provisions, introduced by the Howard Government in 2005, were supposed to encourage people to keep working part-time rather than stopping work entirely. Yet most people using a TTR pension have continued to work full time. In practice the provisions have simply been a gift enabling older people to pay less tax than younger people on similar incomes.

No-one has ever explained why we should have an age-based tax system, beyond the politically cynical observation that these provisions were introduced when demographics produced an unusually large number of voters aged 55 to 64. Some of these voters are now objecting vociferously to losing their privileges – but they were never justified in the first place.

The tax breaks of TTR pensions

Transition-to-retirement (TTR) pensions, as they stand today, have three features. They allow people to withdraw money from superannuation from the age of 60 without tax penalties. They allow older people to continue to contribute to superannuation while they withdraw funds. And they bring forward the age at which earnings on accumulated superannuation balances cease to be taxed (the superannuation earnings of younger people are taxed at 15%).

These provisions are a boon to older taxpayers. One benefit is the opportunity for “super recycling”, in which a person continues to work full-time and to consume their wage income, but pays around $5000 a year less income tax. People over 60 can put the maximum amount into superannuation from their pre-tax income, and then withdraw the money immediately. They pay much less income tax because their contributions to super are only taxed at 15%, whereas ordinary earnings are taxed at their marginal tax rate.

The precise benefit of super recycling varies depending on income, as our recent Super Tax Targeting report shows. For workers aged between 60 and 64 who earn between $65,000 and $150,000, super recycling reduces the amount of tax paid by about $5000 a year. To put this in context, a 60-year old earning $75,000 then pays as much income tax as a 40-year old earning $57,000.

There are also big benefits for an older worker who takes a TTR pension and stops paying tax on the earnings of their superannuation well before they retire. Take someone with a superannuation balance of $500,000 – a larger balance than seven in eight Australian taxpayers of that age – and earning a 6% return. A TTR pension reduces the annual tax paid by around $4,500. If they take a TTR pension at age 56, they will save around $40,000 in tax by the time they stop working at 65. If their superannuation balance is higher, the tax benefit is proportionately larger.

Not a transition to retirement scheme at all

All the evidence suggests the TTR pensions are mainly used by high-wealth individuals to reduce their tax bills while they continue to work full-time. In a study published last year the Productivity Commission concluded that:

…the tax concessions embodied in transition to retirement pensions — designed to ease workers to part-time work prior to retirement — appear to be used almost exclusively by people working full-time and as a means to reduce tax liabilities among wealthier Australians.

The misuse of TTR pensions is reflected in the confusion about how many people will be affected by the Government’s changes. The Government estimates that some 115,000 people will be affected by the change.

Critics counter that the changes could affect more than 500,000 super accounts classified as TTR pensions. But many of these almost certainly belong to people who have in fact fully retired, but haven’t bothered to tell their super fund to change the classification of their pension. They have little incentive to get their paperwork up to date, because the TTR pension already provides all the benefits of tax-free super earnings to which retirees are entitled.

However many people are affected, these arrangements bear little resemblance to the now explicit objective for superannuation – “to provide income in retirement to substitute or supplement the Age Pension”. They don’t encourage additional saving. They do little in practice to delay retirement. Instead they are part of an age-based tax system that allows older Australians to pay less income tax than younger Australians with similar incomes.

Reducing the rorts

So the Government’s announcement in the May Budget that it would reduce the extent of these benefits should be no surprise.

The Government proposed to reduce the amount that can be contributed to super from pre-tax income from $35,000 to $25,000. As a result, a 60-year old earning a wage of $75,000 a year would only save $3,700 per year through super recycling rather than $5,800 per year.

However, there may be little change in practice because the Government also proposed yet another complexity that future politicians will also struggle to explain. People will be able to make additional pre-tax contributions if they contributed less than the limit of $25,000 in the previous five years. Although this is supposed to help women with broken work histories catch up on building their super funds, past practice shows that such provisions are primarily used by older men to minimise their tax.

The government also proposed to tax super earnings at 15% unless a person retires (and so forfeits the ability to make additional contributions to superannuation). Those withdrawing money from their superannuation, but also working and contributing to superannuation, will then pay 15% tax on the earnings of their super fund, just like everyone else still working.

Why the Government should stick to its guns

The Government has been attacked over the last week as it emerges that these changes will affect some people “only” earning $80,000 a year, who might be in the top 20% of income earners, but are not in the top 4%. Coalition backbenchers are reportedly concerned that some of their supporters will pay more tax. Financial planners are nervous that they will have less tax planning to offer.

But the outrage misses the vital question: why do such generous tax breaks exist at all? They lead to individuals with above average incomes paying less tax than younger Australians on similar incomes. They do almost nothing to contribute to the ostensible purpose of superannuation.

For more than a decade, superannuation tax concessions have been absurdly generous to older people on high incomes. They are one of the major reasons why older households pay less income tax in real terms today than they did 20 years ago, even though their workforce participation rates and real wages have jumped.

Superannuation tax breaks cost more than $25 billion in foregone revenue, or well over 10% of income tax collections, and the cost is growing fast. Lower-income earners and younger people have to pay more in other taxes – now and in the future – to pay for the tax-lite status of so many older Australians. The proposed changes are just the beginning of much needed reforms to superannuation to end intergenerational theft from the young.