Farm Management Deposits & the Retirement Trap. What You Need to Understand.
Primary production is often referred to as a game of chance. Fluctuating seasons, changes in demand and commodity prices dictate the rules of the game that no-one can predict. The Business of farming does not beat to the tune of a 30th June deadline which can create a financial headache for many.
To combat the changing face of farming, the ATO provides concessional treatment of income through the use of Farm Management Deposits (FMD). The FMD scheme allows an eligible taxpayer to make a tax-deductible deposit in the year in which the income is earned. The Deposit will result in a reduced taxable income for that financial year. The Scheme then allows a taxpayer to withdraw the funds and recognise the income as taxable in a year where they have experienced an adverse trading position. The scheme allowed a taxpayer to smooth their income over a number of financial periods. The concept of deposit and withdrawal gives a Taxpayer a level of control to achieve the most favourable position for their circumstances.
So, if we achieving a favourable tax position, what can go wrong?
The trap comes from one major change. Retirement. Over time a taxpayer may have banked considerable reserves into FMD accounts through the good business practice of deposits being made in good times and monies withdrawn only as needed. Over time, there is real potential that the balance held in FMD’s could push towards the maximum balance of $800,000. The potential tax trap centers around the decision to cease farming and retire on funds held.
The ATO provides that a FMD is deemed to be repaid when the owner stops carrying on a primary production business for 120 days or more. The amount will be classed as assessable income if a deduction was claimed when it was deposited.
Let’s look at a working example, carrying the maximum FMD balance of $800,000. A taxpayer has made the decision that this financial year will be their last and lodges their Income Tax Return showing they have ceased trading as at 30th June. For the next financial year, we will see the 120 day period expire and an assessable amount of $800,000 will be shown on the taxpayer’s next income tax return. Based on today’s income tax rate, that would result in an income tax liability of $333,097.00. That is 41.64% of the total deposit paid in tax. A very expensive retirement trap!
So how can we avoid the trap? The key word is PLANNING. Determining what the future may look like today, tomorrow and ultimately the day you cease primary production. How long do I want to keep farming? Have we set goals and a timeframe to maximise our retirement funds? Are their family plans for succession and what will that look like? These are all valid questions and ones that can direct how you manage your FMD withdrawal.
What might the options for withdrawal look like?
Here we look at two:
Interim planning before 30th June to identify opportunities to progressively withdraw at a lower marginal tax rate.
Converting a FMD Deposit into a Superannuation Contribution resulting in a maximum marginal tax rate of 15%.
Reviewing your taxable position BEFORE the end of the current financial year can identify an opportunity where funds can be pulled out at a considerably lower marginal rate of tax. For example, a 65-year-old farmer has experienced adverse conditions this financial year. Based on their interim review the farmer has a projected Taxable Loss of $20,000. Based on their age and concessions available there is an opportunity to have a taxable income of $30,000 before they pay any income tax. Therefore the taxpayer has a potential opportunity to withdraw $50,000 with no tax implications.
The second option is crystallising a FMD and converting it to a deductible superannuation contribution. An individual can make a deductible concessional contribution of up to $25,000 per financial year. The Contribution is then taxed to the Superannuation fund at a fixed rate of 15%. In the example an individual who has decided that they will cease farming in the next five years can convert $125,000 at a maximum rate of 15%.
So what can we take from above? Planning and communication is the key to avoiding the retirement trap of FMD’s. A pro-active approach to retirement can result in a healthier financial position with the income tax burden being reduced. A FMD is a great financial tool for a Primary producer to ride the highs and lows of farming, however, the ability to time and plan the withdrawal from the scheme will give the best outcome and reap the highest reward for an individual’s hard work.
If you would like to explore the planning process further to ensure you maximise your retirement position, please call our Schuh Group offices and our experienced accountants can walk through the options available to you.