Leading strategist says ‘member as lender’ borrowing strategy may help SMSFs avoid excess contributions problem

• Financial planners should consider a ‘member as lender’ strategy to help SMSF clients who have contributed up to the limits of the super contribution caps but wish to contribute more to super
• The cap reduction in the 2009 Federal Budget and incoming means testing will make it more difficult for the over 50s age group to make voluntary contributions

Leading technical strategist Strategy Steps is urging financial planners to help clients avoid breaching superannuation contribution caps but still save for their retirement. Self Managed Super Fund (SMSF) clients at risk of breaching the caps could get extra money into super using a new borrowing strategy called ‘member as lender’ which, if set up properly, does not risk cap breaches or the resultant ATO penalties.

“A ‘member as lender’ strategy allows SMSF investors to lend personal (non-superannuation) money to their SMSF which can be invested in assets where investment earnings are taxed at the 15% superannuation investment earnings rate, not the member’s own marginal tax rate,” said Louise Biti, Director of Strategy Steps.

“The strategy will work best for SMSF investors who are already contributing up to the level of the superannuation caps but who have other money that they would like invested in the superannuation environment or who want the flexibility to take their money back out of super should their circumstances change,” she said.

Ms Biti said the 50% cuts to concessional super caps in the 2009 Federal Budget had made it more difficult for people in the over 50 age group to make meaningful contributions at a time when many have the desire and means to do so. “Means testing is proposed to be imposed on the over 50s cap from July 2012 which will make it even more difficult to save tax effectively for a comfortable retirement,” Ms Biti said.

The concessional caps are $25,000 a year for those aged under 50 and $50,000 a year for those over 50. The $50,000 cap is set to drop to $25,000 on 1 July 2012, except for those with less than $500,000 in super. The non-concessional cap allows a further $150,000 per year in after-tax contributions.

In using the member as lender strategy, the SMSF will have to pay a market interest rate on the loan being advanced to it by the SMSF investor.  This means some investor earnings will still be derived outside super and taxed at marginal tax rates, but the difference between the net investment earnings in the SMSF and the loan interest rate can be significant when market returns are positive and will compound due to the tax effective environment of super.

Consider the simplified example of Rex who invests $100,000 outside super. If this money earns a 15% per annum return, it is taxed at marginal rates. Alternatively, Rex lends $100,000 to his SMSF, his fund invests it and earns the same 15% per annum. The SMSF pays 8% per annum interest (market rates) on the loan to Rex who pays tax at marginal rates of up to 46.5%, but the remaining 7% earnings is taxable income in the SMSF at a maximum tax rate of 15%. Over a 10-year period this could amount to an additional $13,000 net earnings, and even more depending on how capital gains tax is managed.

“A member as lender strategy is also useful for SMSF investors who want the option of retrieving their money from their SMSF if their circumstances change without having to wait for a condition of release (like retirement). In that instance, the loan can be repaid and the money returned to the member,” said Ms Biti. Only accumulated earnings would remain in the SMSF.

Ms Biti said savvy financial planners should note that this strategy will become even more attractive as they prepare their clients for a post 1 July 2012 world when the super caps drop to $25,000 for the over 50s who don’t meet the means test, and, as the understanding of the rules for borrowing in SMSFs become better understood.

However, she cautioned that financial planners should compare the benefits to individual SMSF investors of the strategy against the cost of the loan arrangement. Careful documentation is also essential to ensure all relevant rules for limited recourse loans are met.