As the Bank Inquiry dominated news headlines in recent days the government announced a change that will certainly be very welcome for some families with Self Managed Super Funds (SMFS). Until now the most people allowed in an SMSF fund was four – the government has announced it intends to allow the limit move to six people.
The timing is especially useful since some families are reviewing their SMSF arrangements in the light of the ALP plans to scrap cash refunds for franked dividends.
One way to mitigate the impact of the ALP proposal is to include adult children in the SMSF so that the franking credits generated by the parents’ share portfolio can at least be used to pay the tax generated by the children’s super rather than being wasted.
But there are some problems with this idea.
To put some real figures around this issue, let’s assume an SMSF has two members and $1.5m in assets (combined). Both members have retired, stopped making contributions and are receiving pensions from their fund.
The fund earns around 4% in investment income each year (a combination of dividends, rent, interest) in addition to any growth in the value of their assets. Around 50% of the investment income is franked dividends. This means that in addition to receiving the cash dividends of $30,000 (4% x 50% x $1.5m), the fund will receive franking credits – these will be around $12,857. Under current law, the fund would pay no tax and would receive a tax refund of $12,857.
Under the ALP proposal the fund would still pay no tax but would not receive the $12,857 refund. In other words, if the ALP measure is introduced as planned, the fund (and therefore the members) will be $12,857 poorer every year.
What if the couple included their adult children in the fund?
If the children are working, their employer could contribute to the fund, creating more taxable income (which in turn will use up the franking credits rather than wasting them). Or the children could make personal contributions for which they claimed a tax deduction.
Let’s say the employer contributions made for the children were as high as possible ($25,000 each). At the moment, only two children could be included in the SMSF before the four member limit was reached so this would help but would not entirely solve the problem. Adding the children’s contributions would now mean the fund would use $7,500 of the franking credits (the amount of tax that would normally be due on the contributions). But the family would still waste the rest of the franking credits ($5,357).
(Note that it would also be possible – and reasonable – to make sure that the benefit of being able to use some of the franking credits passed to the parents rather than being a windfall for the children, given that it would be the parents’ investments that created the opportunity in the first place. This is something that would be worked out by the fund’s accountant)
Is there any way of making sure the fund uses up all of the franking credits?
In fact, it is difficult. Even if the children transferred their own superannuation balances into the fund (and so the fund paid income tax on some of its investment income), this would also mean that the fund would have more investments and probably more franking credits.
Really what the fund needs is more taxable contributions. This is why large funds (such as industry funds and retail funds) not affected quite so much by the ALP proposal. Even though these funds might have many more pensioners than an SMSF, they also have many more members receiving employer contributions. It is also why the latest announcement about increasing the limit on SMSF members to six will be particularly interesting to those with larger families. Parents in this position with four children (or two children and their spouses) with the maximum rate of taxable contributions would be able to use all the fund’s franking credits.
Of course, this relies on couples conveniently having family or others who can direct large contributions to the fund and want to do so.
Nonetheless, where feasible, it is likely that including children and possibly even extended family in an SMSF will be a common response if Labor’s proposal is introduced. As the figures above show, it will certainly help make better use of the franking credits that might otherwise be wasted, particularly in a pension fund.
But there are downsides to including the couple’s children in their fund.
Firstly, new members are generally also required to be trustees of the fund. This means the children become decision makers when it comes to the running of the fund. There are some protections that can be put in place but at the very least the fund’s trustees must make decisions with the interests of all members (including the children) in mind. Even now (when funds are limited to four members), if one parent dies there is a risk that the children (combined) have more control over the fund than the surviving parent. In a six member fund (four children) this problem exists from day one.
If a couple has too many children (more than two at the moment or more than four in the future) , some must miss out. This may not be a problem (who really wants to belong to their parents’ superannuation fund anyway?). But it does create the potential for the children who are not in the fund to feel they have been excluded.
Finally, adding the children to the parents’ fund may disrupt the children’s own superannuation planning – at the very least it may delay their ability to set up their own SMSF with their spouse. It is also an arrangement that will need to be unwound at some point – for example, once the parents die, will the children want to continue combining their superannuation arrangements? Even this has some solutions – the children could routinely roll out most of their superannuation contributions to their own fund, the contributions just need to be made to (and taxable in) their parents’ fund. But then life starts to become more complicated.
So while adding children to an SMSF may provide a better tax result by making sure more of the franking credits are used, it won’t necessarily be right for every family.