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NEWS - PLANNING
Tips to accumulate retirement wealth
8/20/2001
People building wealth for retirement often have two broad types of income they need to make important decisions about: salary or business income, and investment income.
In each case, the way they choose to derive the income, and what they decide to do with it, can make a huge difference to the amount of money they end up with.
Employees earning a salary, for example, are often given the choice of taking it all as cash, or as a combination of cash and fringe benefits.
While there is still a certain pose value attached to having a salary package stacked with all sorts of goodies, the advantages of packaging are not what they used to be.
Packaging a car can still be beneficial but you need to be doing at least 15,000 kilometres [a year] and be on the top marginal tax rate to get the tax benefit of a packaged car.
Exchanging some cash salary for extra super contributions, made on your behalf by your employer, can also be tax-effective.
If your marginal tax rate is greater than 30 per cent, you're better to salary sacrifice to super than take it [the salary] as cash. But when it comes to packaging other items, including those exempt from fringe benefits tax, the advantages are questionable.
There's also a risk that if you want to borrow money, a lender will assess you on your cash salary alone, not on your total package.
Similarly, it's important to find out if things such as compulsory super and income protection insurance are based on your cash salary or the total package. Don't do it just because you think it's smart to package. If you think you are getting a tax advantage, ask, are you really?
The introduction of the superannuation surcharge in 1996 breathed new life into salary packaging, says Paul Maddock, general manager of technical services at MLC.
"Until the rules were changed in April 1999, you were able to receive some things as fringe benefits, and they were not included in your adjusted taxable income [the figure that determines whether you are liable for the surcharge] but the Government then moved to close that opportunity" Maddock says.
The executive chairman of ipac, Arun Abey, says the operation of the FBT has "tremendously narrowed" salary packaging opportunities.
He agrees that cars and super are the two main candidates for packaging these days. In particular, employees should think about converting any cash bonuses into extra super contributions, he says.
(Employees must give advance warning of their intention to salary sacrifice any bonuses.)
Despite the potential benefits in packaging cars and super, there are some who believe it's best to take all your salary as pure salary.
"I am a great believer in the KISS ["keep it simple, stupid"] principle," says Peter Thornhill, principal of Motivated Money.
"If you begin to get a bit convoluted with what you do with your money, you start to lose track of what you are doing.
"I like to see what my expenses are, what my income is, so I can match them.
"If I am not seeing my expenses [because some of them are packaged], I might become a bit blasé."
Thornhill sees the potential tax breaks in salary sacrifice super, but is nervous about the Government's long-term intentions in this area, likening it to the "boiling frog" syndrome.
"If you put a frog into boiling water, it will jump out. But if you put it into tepid water [the superannuation tax regime] and heat it up slowly, the frog dies," he says.
Thornhill thinks disciplined investors are better off building retirement savings outside super, using a gearing plan.
He's particularly keen on the idea of gearing into shares, and using the dividend income to repay your home loan. When you have built up enough equity in your home, you can borrow against that to buy more shares, using a home equity loan.
"By recycling your dividends in this way, you can wipe off your home loan and turn non-deductible debt into deductible debt," he says.
Growth investments, such as shares and property, are generally favoured over income-only investments, such as cash and term deposits, during the so-called accumulation phase - particularly for those gearing their portfolios.
Says Abey: "During the accumulation phase, assuming you have no need for cash flow top-up, the focus should be very much on growth.
"A geared portfolio into cash or bonds does not make sense, but gearing into a growth portfolio of reasonable quality is pretty attractive."
Abey says the ability to defer the sale of growth assets, and hence the payment of capital gains tax, is another advantage, particularly if you can pick a time when you're in a lower tax bracket. (If the assets have been held for at least 12 months, you pay tax on only half the nominal gain, he says.)
As a general rule, people should be looking to maximise the total return - income plus capital growth - from their portfolio rather than trying to maximise one or the other. But if you are in the accumulation phase and not needing the income to spend, generally growth is going to provide more benefit than income.
Wealth will accumulate better with capital gains, but the problem with capital gains is the volatility. Once you have earned them, they can be wiped out. But when you get income, you keep it.
Capital gains are generally more tax-effective than straight income. But you need to look at the risk aspect, be comfortable with the volatility and be sure you have the right time-frame to handle the volatility.
Thornhill is all in favour of targeting growth assets, particularly shares, during the accumulation phase.
But he urges people to remember that the capital gains derived from shares and other assets are a function of the income stream that the assets generate.
"Without the income, you get no capital gain," he says. "Why people think assets should go up in value for no good reason just knocks my socks off."
Thornhill encourages investors to buy shares with a stable, reliable dividend stream that will grow over time rather than shares focused solely on capital growth, which is far less predictable.
Receiving a stable income stream from dividends is far preferable to selling shares to produce your income, he says. "It's an unnecessary erosion of your asset base that could be avoided."
But according to Abey: "Growth investments are called growth investments because, over time, one expects to get a growing income stream from them.
"They are not called growth investments because they produce capital gains. It's because they produce a growing income stream, which in turn leads to capital growth.
"With income-only investments, the income stream does not grow and there is no long-term increase in capital value."
For this reason, people are encouraged to maintain a reasonable exposure to growth assets, even when retirement is looming.
People should not think so much about changing their asset classes, like shares to income-only investments. Rather, they should think about shifting more towards liquidity as they get towards retirement. They are not just looking at the accumulation of wealth, but looking at how you are going to get income from that.
People should also consider transferring more funds into super, because superannuation income streams are a very tax-effective way of generating retirement income.
Maddock says there is often no need for people to change their asset allocation as they near retirement, particularly if they are in a balanced fund (about 70 per cent growth assets) or a growth fund (about 85 per cent growth assets).
The past 10 years have seen a big change in attitude, he says. Rather than making changes to their asset allocation pre-retirement, investors are focusing more on strategic and structural changes, he says.
For example, people generally unwind any gearing arrangements and pay back their borrowings.
They might also consider withdrawing part of their super benefit (up to the post-1983 low-tax threshold) and reinvesting the amount as an undeducted contribution, for which no tax deduction is claimed.
"This can increase the amount of tax-free income an individual can receive each year [in retirement] - in addition to the $30,500 that is already tax-free as a result of various rebates," he says.
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