Top Up Super or Pay Off Mortgage?
Should you smash the home loan? Or contribute extra to super? Does one strategy beat the other or is it just same-same?
On one side, paying off the home loan earlier would free up cash flow to let you make extra super contributions. On the other, perhaps it would be better to build up extra super so you can pay down your mortgage in a lump sum.
The perceived wisdom seems to be pay down the home loan first, and then shovel money into super. But under certain conditions, you might actually be doing yourself out of dough if you follow this approach. Particularly, in environments of low interest rates and reasonable investment returns, and for those on specific incomes.
A strategy of salary sacrifice (where you contribute to super on a pre-tax or concessional basis) over mortgage repayments isn’t going to work for everyone. But from an income perspective, there are sweet spots where it works well and can add a few thousand dollars a year to your kitty.
The basis for the potential benefits comes from a few different sources. The first is the tax difference between marginal tax rates and the tax on super contributions. Marginal tax rates are up to 47 per cent, while concessional contributions to super are taxed at 15 per cent.
For Sally, an employee earning $105,000 a year, the overall tax saving from salary sacrificing $15,000 of income is $3600 ($15,000 x 24 per cent, which is the difference between her marginal tax rate of 39 per cent and a super tax rate of 15 per cent). Each year that salary sacrifice continues, there’s an extra $3600 going into the super fund, earning and compounding over the years, rather than going to the tax office.
Second, that extra money is earning income that, most years, in a ‘‘balanced’’ fund, is probably earning more than the interest you’re paying on your home loan, even after tax.
Home loan interest rates, at the moment, are around 4 per cent. Over the medium term, a balanced fund is likely to return around 6.5-7 per cent. Some tax is paid on those earnings (versus none on the money you saved in interest), but at super tax rates this is 10-15 per cent and still likely to put the super fund ahead.
Let’s combine both the first two benefits into an example. Let’s take someone on a $105,000 income, with 9.5 per cent superannuation guarantee paid by the employer. They have room to put in up to $15,025 as salary sacrifice to stay under the $25,000 annual concessional contribution limit.
We’ll use $15,000 as a comparison. The choices are using that $15,000 to pay down the home loan, or to salary sacrifice into super.
Instead of using $9150 ($15,000 less 39 per cent MTR) to pay off the home loan, you get $12,750 ($15,000 less 15 per cent contributions tax) into your super fund.
Against the mortgage, that $9150 is saving you about $366 a year in interest (assuming 4 per cent) payments. Simple total is $9516.
However, if the $12,750 that went into your super fund is earning you about $785.40 (assuming a 7 per cent return, then taxed at 12 per cent), again, the simple total is $13,535.40.
Third, the compounding nature of both makes for potentially powerful returns over time. And if you’re part of a couple, potentially double so, if it makes sense for both of you to do it.
The example above shows a potential benefit of about $4000 a year. If a person started doing this at 55 and was ready to retire at 62 to draw on their super, they would have created an extra $30,000-$40,000 to pull out to pay down the mortgage, if they haven’t already. Again, it’s even more powerful if both members of a couple are doing it.
It has all become much easier to do in the last two financial years, with the removal of the ‘‘10 per cent rule’’, which has allowed all employees to make tax-deductible contributions directly to their own super fund and not have to rely on salary sacrifice options being offered by their employer.
Does the strategy work for everyone?
No. There is a sweet spot between incomes of about $60,000-$150,000 where it might make the most sense.
Why? If you’re earning more than $150,000, the ability to make meaningful extra concessional contributions begins to diminish. That is, if you’re earning $180,000 a year, then your employer is tipping in $17,100 in terms of superannuation guarantee payments and you could only tip in up to $7900 as salary sacrifice, or other concessional contributions.
If your taxable income is much below the $60,000 mark, will you have the disposable income after your expenses to make considerable extra contributions?
On incomes below $37,000, you would only be swapping a marginal tax rate of about 21 per cent (including Medicare) for the 15 per cent super contributions tax, which will take most of the benefits away.
So, incomes between $37,000 and $45,000 or so would have limited benefits, before changing from the 34.5 per cent MTR to the 21 per cent MTR (heading south).
If you’re already making the sacrifice to put extra into super and find yourself reaching your limits, then the benefits are limited for you.
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The above information has been sourced from The Australia. To read the full article CLICK HERE.