Buying a property using your super means setting up a Self-managed Super Fund (SMSF). There are many advantages and disadvantages of SMSF which you need to understand if you are considering setting up one. As you can see an SMSF may not be a right choice for everyone.
What is Self-managed Super Fund (SMSF)?
Usually your superannuation, which is savings for your retirement, goes to a superannuation fund. There are different kinds of super funds, for example retails funds (run by banks and companies), MySuper (Australian government superannuation initiative to provide low cost and simple super fund), Public section fund (for employees of Federal and State government departments), etc. Normally you can access your super only when you turn 65. However, even with a superannuation fund you can control, to some extent, the way your super money is invested. For example, you can set % of your fund to be invested in blue chip shares, other shares or bonds.
When a super fund is a complying super fund only 15% tax applies on before tax super contributions within the specified limit. In order to be a complying super fund a fund must comply with the Superannuation Industry (Supervision) Act 1993.
Self-managed super fund is another way of saving for your retirement. There will be similar tax concession in case of a SMSF if it is a complying SMSF. SMSFs are regulated by ATO, which also issues notice of compliance to SMSFs. When you set up a SMSF, you will be a member as well as trusty of the fund. As a trusty you will be able to control the fund but you will also be responsible for complying with super and tax laws.
A SMSF can have maximum of four members. It can have only one member but there must be at least two trustees.
SMSFs are started for variety of reasons including increased control, flexibility and tax benefits. Here are some of the specific benefits.
- To save super fees: All super funds charge different types of fees including Administration fees, Investment fees, Advice fees, Switching fees etc. Super funds charge different levels of fees and some funds charge very high fees compared to other. According to research group Canstar annual super fees for a $140,000 super balance can range from $728 to $3,966 (0.52% to 2.83%). An annual difference of $3k will have a huge impact over the period of 20 years.
With SMSF too you will be incurring administrative (mainly accounting, auditing and tax return) and investment fees. According to ATO data, for a SMSF with fund between $500k and $1m there was around 0.8% administrative expenses and 0.78% investment expenses for 2016 on average. Many of the SMSF’s expenses are fixed expenses which means total expenses ratio will be higher for small funds and lower for big funds. Therefore, in order to save super fees, the fund size will have to be big, at least above $300K.
There will be further savings for SMSFs that directly invest rather than through investment manager as the funds will not have to pay fees based on a percentage of their investment.
- More investment options: SMSFs can invest in different types of assets which are not available for ordinary super funds. For example, SMSF can invest in properties, unlisted shares and even artworks.
However, any such investment should be purely for providing of retirement benefit. Therefore, any residential property purchased by an SMSF can only be rented to unrelated third party; it cannot be used by members or their relatives. There is one exception to this rule, an SMSF can invest in a commercial property which can be rented to a member at market rate for conducting business.
- Tax benefits of SMSFs: SMSF can be used to minimise tax burden in certain circumstances. If you have very high income in a tax year due to capital gain or high performance bonus you can contribute two years’ worth of concessional super contribution in the tax year and pay only 15% tax instead of marginal tax rate on the contribution. Your SMSF can allocate the extra contribution to you only in the next financial year, so you will not incur excess contribution charges. Provided all the associated legal requirements are met, this is a valid strategy under the tax and super laws according to the view outlined in Taxation Determination TD 2013/22.
Capital gains tax benefit – When a member of an ordinary super fund move into pension phase the fund needs to sell the assets the fund has invested for the member and pay necessary capital gain tax. However, with SMSF it is not necessary to liquidate any assets to move into the pension phase, which will avoid any capital gain tax.
- SMSF can borrow money to invest: With possibility of borrowing SMSFs can purchase residential or commercial properties. SMSFs loan arrangement is called limited recourse loan which will have certain restrictions as to how much can be borrowed and what can be done with the property.
Disadvantages and challenges of SMSFs
Before rushing into setting up an SMSF you must understand its disadvantages and challenges and decide whether SMSF option is right for you.
- High cost for small fund balances: Think carefully before setting up an SMSF if your super balance, together with up to three of your close friend/ relatives who can be members, is less than $300K. For anything smaller, cost of running the fund is likely to be more than an ordinary super fund fees.
- Time consuming: Members/ trustees will have to spend significant time to run their SMSF even when they use professional SMSF administrator or financial planner.
- Penalty for non-compliance: The ATO as a regulator can withdraw a fund’s complying status for serious non-compliance with super laws. This will result in market value of non-complying fund less any non-concessional contributions being taxed at the highest marginal rate. If super laws are breached, administrative penalties are levied on each trustee.
- Members should have investment knowledge: Members of SMSFs should know basics of sound investment practices and should at least be able to ask right questions to their financial advisers.
- Risk of poor diversification: Generally SMSFs are set up to buy a single rental property and fate of the fund depends entirely on performance of that asset. The risk is amplified if a single asset of a fund is purchased using borrowed fund.
- Limited recourse borrowing arrangement (LRBA): When a property is acquired by an SMSF using limited recourse borrowing the property cannot be knock downed and rebuilt or buy vacant land and build. Such property cannot even be altered if such alteration fundamentally changes character of the property.
LRBA is a long terms arrangement, so it is important that your SMSF is able to repay the loan instalment over the period. The property cannot be quickly sold for loan repayment if the fund struggles to repay interest and principal instalment. Further, interest rate is also higher in case of a LRBA.
- Negative gearing: If an SMSF invests in a negative gearing property the tax benefit for the SMSF will just be 15% whereas if a member acquires the same property as investment property he/she will save tax at his/her marginal tax rate.
(This article is for general information purpose only. Please consult an SMSF expert for suggestions based on your particular circumstances)