What is the Transfer Balance Cap and how does it work?
A few weeks back in the piece about the Superannuation Sweet Spot, I made reference to the transfer balance cap of $1.9 million. I’ve since had a few questions about how this operates, so this week I thought we’d dig into some extra detail on this particularly important piece of the superannuation rule book.
Transfer balance caps are a relatively new invention within Australia’s superannuation system, having been introduced on the 1st of July 2017. Their purpose is to ensure that the generous tax concessions offered within our superannuation system are distributed somewhat equitably across the entire community, and are sustainable over the long term. They became necessary due to a change around a decade prior, where superannuation savings in the pension phase became entirely tax free. Those with very large superannuation balances, producing far more income than they could ever spend, were nonetheless enjoying it all tax free.
Whilst the transfer balance cap was not retrospective, so people in this circumstance continue to have this wonderful benefit, over time the imposition of the cap, along with restrictions on how much can be contributed into superannuation, will mean that the problem of extreme balances in tax free environments will dissipate, as the members of those funds pass away and their excess savings are distributed to the next generation.
The transfer balance cap is relevant to the moment in time when your superannuation savings switch from being in accumulation to pension phase. At that point in time, an assessment is made comparing your superannuation balance against the cap. Right now the transfer balance cap is $1.9 million. I understand that next financial year it will be increased to $2,000,000, as it has a process of adjusting to inflation every few years.
This cap figure is the maximum amount of superannuation savings that can be placed into a tax free pension. If your superannuation savings are in excess of this cap, that excess portion must be left behind in the accumulation phase of your super. This means it continues to pay tax of 15% on earnings and 10% on capital gains. This is in contrast to the portion of your savings now in the pension phase, which has a 0% tax rate on all earnings.
For most people at this level of wealth, the tax applied on accumulation within superannuation remains quite attractive, so having excess superannuation savings is far from disastrous.
A key thing to be aware of, is that your assessment against the cap is not ongoing. Confusion here is what leads to the majority of the questions that I receive.
Imagine you have retired and your superannuation savings are just under $1.9 million. You therefore convert your entire superannuation savings into a tax-free pension and start drawing regular income.
Because you’ve received great financial advice, the balance of your new pension account grows as investment values appreciate. Six months down the line, your balance is $2,000,000.
Upon receipt of this otherwise good news, you might be inclined to panic. Have you now breached the transfer balance cap? What penalties are you going to get hit with?
Fortunately, you needn’t worry. The transfer balance cap assessment happens only once, at the point at which you convert to the pension. What happens to your balance from that moment forward is of no consequence at all.
I mentioned earlier that the cap is expected to be increased to $2,000,000 next financial year. Another common question I get is from those who have used up all their transfer balance cap in the past, and now wonder if that gives them an extra $100,000 that they could throw into the tax free pension.
The short answer is no. The longer answer is that when you trigger the transfer balance cap assessment, the ATO measures your balance as a percentage of the cap. From that point on, any additional superannuation pension commenced or topped up will be assessed against the percentage of the cap you have available, and the relevant cap in the particular year that you are hoping to make that contribution.
To illustrate, if you put $1.9 million into a superannuation pension this financial year, you have used up 100% of your cap. The fact that the cap increases to $2,000,000 next year does not create an extra $100,000 of headroom for you. You continue to have used up 100% of your cap, and can never put any more money into a tax free pension.
Alternatively, let’s say you put $1.5 million into a superannuation pension this year. Here you have used up approximately 79% of your cap. When the cap increases to $2,000,000, and more in subsequent years, you would always have available 21% of the relevant cap in that year should you have additional funds to put into a tax free pension, most commonly as the result of an inheritance.
A final point to consider is that transfer balance caps are assessed at the individual level. Frequently, superannuation balances are not spread evenly across a couple. From the perspective of tax optimization, it is beneficial to adopt strategies that rectify this as much as possible within the constraints of the contribution caps. If one member of the couple ends up with $2.2 million in superannuation, whilst the other has only $100,000 in superannuation, the person with the large balance would have $300,000 that they can’t get into a tax free pension, whilst their partner has a very large amount of unused headroom. The transfer balance cap is a very good reason to work towards ensuring both members of the couple have solid superannuation balances, and that your wealth is distributed as evenly as possible across both names.
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