Making a deductible super contribution after redundancy

By Stuart Sheary, Senior Technical Manager

Making a deductible super contribution after redundancy - Is it tax effective?

Certain lump sum payments including eligible termination payments, unused leave entitlements paid on redundancy and some lump sum superannuation withdrawals are subject to a maximum rate of tax. Understanding how a maximum tax applies to income can be confusing particularly when deciding whether to make a deductible contribution to super.

Using a case study, we aim to clarify the interaction of income, subject to a maximum rate of tax, with ordinary income as well as identify the effectiveness of deductible superannuation contributions.

A redundancy payment can result in a large spike in taxable income. Clients who are made redundant often wish to reduce tax liability and invest part of their payout. Making a personal deductible contribution to super can achieve both these goals.

Case study – Neesha

Neesha, age 60, has been made redundant. She is considering making a $10,000 personal deductible contribution into super but is unsure as to whether this will reduce her personal tax liability. Her redundancy payout qualifies as a genuine redundancy for tax purposes. She has been employed for a little over 15 years and has received the following amounts for the 2020-2021 financial year.

  • Salary up to last day at work $25,000
  • Severance payment of $150,000
  • Annual leave of $25,000
  • Long service leave of $25,000

These different sources of income are subject to different tax treatment. The salary of $25,000 is taxed at ordinary marginal rates. The annual and long service leave together with part of the severance payout are subject to a maximum rate of tax.

Annual and long service leave paid in consequence of genuine redundancy

Annual leave and long service leave paid as a lump sum in consequence of a genuine redundancy is generally taxed at a maximum of 32% including Medicare Levy. An exception is long service leave relating to period pre 16 August 1978, only 5% of these amounts are assessable and tax at the client’s marginal tax rate.

Type of leave Service Period Assessable incomeTax
Annual Any service period 100% 32%
Long service Pre 16/08/1978 5% Marginal
  Post 15/08/1978 100% 32%

Tax free genuine redundancy amounts

A severance payment may be tax free if the payment qualifies as a genuine redundancy under tax-law. There is a limit on how much of the severance (genuine redundancy) payment is tax-free. For the 2020/21 financial year the tax-free genuine redundancy amount is limited to $10,989 + $5,496 for each completed year of service.

In this example, someone employed for a little over 15 years will have 15 full years of service and therefore their maximum tax-free genuine redundancy amount is $93,429 ($10,989 + (15 x $5,496)). Please note this figure reflects the maximum redundancy payment that can be tax-free. The actual redundancy amount paid may be greater or less than this amount.

Redundancy amounts in excess of the tax-free component are employment termination payments (ETP). ETPs within the current ETP cap of $215,000, or where applicable, the lower whole-of-income cap ($180,000 less other taxable income in the income year) are taxed at concessional rates.  Payments above these caps are taxed at the highest marginal rate plus the Medicare Levy (47%). This is illustrated in the table below:

Age at 30 June in FY of paymentEmployment Termination Payment (ETP)Tax rate*
Under preservation age

ETP cap ($215,000)

WOI

Up to 32%

 

Excess amounts

47%

Preservation age or over

ETP cap ($215,000)

WOI

Up to 17%

 

Excess amounts

47%

*Includes Medicare levy

In this example, Neesha’s severance payment is $150,000 and the genuine tax-free payment is $93,429. The portion severance payment ($56,571) that exceeds the tax-free genuine redundancy limit will be taxed as an employment termination payment (ETP).  As Neesha has attained preservation age and the ETP falls within the ETP cap of $215,000, it is taxed at a maximum 17% including Medicare Levy.

Lump sums subject to a maximum rate of tax

Lump sums subject to a maximum rate of tax such as ETP, lump sum leave payments and taxable superannuation lump sums add towards Neesha’s assessable income. As amounts within the relevant cap are subject to a maximum rate of tax these amounts are taxed at the lesser of the applicable marginal tax rates and the maximum tax rate.

The maximum lump sum tax rate is achieved via a tax rebate which brings the tax liability on that lump sum amount down to the maximum rate where marginal tax rates would otherwise result in more tax.

Income subject to a maximum rate of tax is layered1 and counts after ordinary income so that it does not ‘push’ other income into a higher tax bracket.

It is assumed that income with the lowest maximum rate of tax (highest rebate) count last after income with a higher maximum rate of tax (lower rebate). Ordinary income forms the lowest layer of income and benefits from the lower tax rates including the tax-free threshold. This means that Neesha can receive the most favourable tax outcome.

Application

In this case, Neesha’s taxable income is $131,571 which includes the $25,000 of salary, $50,000 in leave payments and an ETP of $56,571 (amount in excess of the tax-free payment limit). Neesha considers making a $10,000 personal deductible contribution to reduce taxable income. The two scenarios are compared in in the chart below.

layered income graph

Termination payment

In this case the maximum rate of tax on the ETP is 17% (Including Medicare levy). This $56,571 ETP is taxed at the lower of the marginal rate of tax and the maximum rate of tax of 17%2. In this case the $56,571 falls within between two tax brackets being 39% (income between $120,000 – $180,000) and 34.5% (income between $45,000 – $120,000). As the maximum rate of 17% is lower than marginal rates of tax this rate applies to the top $56,571 layer of income relating to the ETP. The reason why this amount forms the highest layer of income is because this results in the largest rebate and is most favourable for Neesha.

Annual leave paid on genuine redundancy

Annual leave forms the second layer of income as the maximum tax rate is 32% including Medicare levy. This is subject to tax at the lesser of marginal rates (falling between two brackets 34.5% and 21% including Medicare levy) or 32%. The 32% maximum rate of tax is more favourable than 34.5% tax and less favourable than 21% tax. Consequently $20,000 of the annual leave ($50,000) will be subject to ordinary marginal rates of 21% and the remaining $30,000 of the lump sum that would otherwise be subject to 34.5% tax will be taxed at the maximum 32%.

Ordinary income (including salary)

The salary together with part of the lump sum annual leave payment is taxed at marginal rates and will benefit from the lowest marginal rate (21% including Medicare levy) and tax-free threshold.

What are the implications of making a personal deductible contribution of $10,000?

A personal deductible contribution of $10,000 will reduce taxable income. Instead of having $131,571 of taxable income the client’s taxable income will reduce to $121,571.

Termination payment

The tax on the $56,571 termination payment will remain unchanged and subject to tax at 17%, including Medicare levy.

Annual leave paid on genuine redundancy

Annual leave forms the second layer of income subject to tax at the lesser of marginal rates (falling between two brackets 34.5% and 21% (including Medicare levy) or a maximum tax rate of 32% (including Medicare Levy). The 32% maximum rate of tax is more favourable than 34.5% tax and less favourable than 21% tax. $30,000 of the $50,000 annual leave will be subject to ordinary marginal rates up to 21% and the remaining $20,000 (not $30,000 as per before) of annual leave will be taxed at the maximum 32%.

Tax saving

By making a personal deductible contribution into her super, Neesha’s personal tax including Medicare levy can reduce by $3,332 in the 2020/2021 FY as a result of reduced taxable income and the $132 Low and Middle Income Tax Offset (LMITO). After considering the $1,500 (15% x $10,000) contributions tax on his personal deductible contribution, she can save approximately $1,832 ($3,332 – $1,500).

No deductible super contributionIncomeRate of taxTax
Salary and $20,000 of lump sum leave pay $45,000

Marginal rates 0% - 21%

$5,992
Remaining lump sum leave pay $30,000 32.0% $9,600
All ETP $56,571 17% $9,617
Total$131,571Personal tax$25,209
  

$10,000 deductible super contributionIncomeRate of taxTax
First $45,000 Marginal rates 0% - 21% $5,992
  $20,000 32% $6,400
  $56,571 17% $9,617
  LMITO-132
 $121,571Personal tax$21,877
    
   Personal tax saving $3,332
   Contributions tax $1,500
  Net saving $1,832

Conclusion

Calculating the tax savings on making a personal deductible contribution can be complex particularly where a client has income subject to a maximum rate of tax. The recent changes to the income tax thresholds combined with the impact of other tax offsets such as LITO, LMITO and in some cases SAPTO can add further confusion.

As there is no ‘rule of thumb’ it is necessary to run a calculation as to the tax saving based on the specific circumstances of your client.

1Explanatory Memorandum, Taxation Laws (Superannuation) Amendment Bill 1989
2CCH IntelliConnect, Australian Federal Tax Reporter Commentary (ITAA 1936) Archive.


More information

If you have any questions, or would like more information, please contact the IOOF TechConnect team on 1300 650 414.Disclaimer
The information in this section of the website is intended for financial advisers only and is not to be distributed to clients. It has been prepared on behalf of Australian Executor Trustees Limited ABN 84 007 869 794 AFSL 240023, IOOF Investment Management Limited ABN 53 006 695 021 AFSL 230524, IOOF Investment Services Ltd ABN 80 007 350 405, AFSL 230703 and IOOF Ltd ABN 21 087 649 625 AFSL 230522 based on information that is believed to be accurate and reliable at the time of publication.