It’s the perennial question. You’ve got some spare income at the end of each month and you want to make the most of it. So where do you put it – in your mortgage or super? The answer is, it depends.
“In general, the further away from retirement you are, the better you are paying off the mortgage. The closer to retirement, the after-tax benefit of super may be better”, says Craig Day, Head of Technical Services at Colonial First State. However, Day says working out the best strategy will depend on your individual circumstances, your personal tax rate, the interest rate on your mortgage, investment returns on your super and the time you have left until retirement.
Putting after-tax income into the mortgage gives you a tax-free return equal to the mortgage interest rate. If the mortgage interest rate is five percent, any additional payments will give you a tax-free return of five percent in the form of reduced interest expenses each year. But the pendulum can swing in favour of super when you take tax into account.
Say you have $100 pre-tax income to spare each month and you are in the 39 percent tax bracket. Once you pay tax on the income you are left with $61 to put into your mortgage. But if you make a concessional (pre-tax) super contribution you pay 15 percent contributions tax, leaving you with $85 to invest. But, the maths doesn’t end there. Earnings on that $85 you invested in super will be taxed at 15 percent.
Depending on the level of risk you are prepared to take and the return you receive, the compounding 5 percent tax-free return from your mortgage may still come out on top depending how long until you have until retirement. Putting this all together, if you still have 20 years to go until retirement, the best option may be to use your surplus cash flow to pay down your mortgage. However, as you approach retirement there may be a tipping point where it makes more sense to switch and start directing the extra amounts into super.
Sarah's Dilemma
Sarah, 45, earns $80,000 a year and has $300,000 in super. She still owes $400,000 on her mortgage, with a minimum monthly repayment of $2,307 at an interest rate of 5 percent pa. She has a spare $100 a month in pre-tax income and wants to know whether she would be better reducing her mortgage or boosting her super.
Day calculates three scenarios to help her decision-making:
If Sarah makes additional mortgage repayments of $100 a month for the next 20 years she will reduce her mortgage by an additional $33,294 by retirement.
If she salary sacrifices $100 a month into super she will save an extra $34,840. So Sarah is $1,545 better off investing in super over her mortgage, based on the conservative cash option for a return of 3 percent a year. “When she’s 60, she can pull the extra tax-free contributions out of super and repay her mortgage”, says Day.
If she makes additional mortgage repayments for the first eight years then switches to salary sacrificing for the remaining 12 years, she will be $2,844 better off than salary sacrificing every year and $4,390 better off than making extra mortgage repayments every year. The actual outcome will be different for everyone.
If you pay income tax of 15 percent or less, there is no tax benefit from super. Super also carries legislative and market risk. Future governments could reinstate the taxation of lump sum withdrawals in retirement or make pension income streams compulsory. Recent changes to super also make additional contributions less attractive if you are already close to the new $25,000 concessional cap. And people on incomes above $250,000 now pay contributions tax at the higher rate of 30 percent, which reduces the benefit of adding to super.
If you’ve got cash to spare and are weighing up whether to put it in super or your mortgage, your adviser can help you do the maths
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