Should you take your Long Service and Annual Leave as a lump sum or regular payments before Retirement?

Many employers offer you the choice of whether to take your annual and long service leave entitlements as a lump sum or regularly payment in the lead up to retirement. This leads to a common pre-retirement planning question: What should I do?

Let's break it down for you...

Step 1: Check you and your partners (if applicable) eligibility for the government age pension:

• Age: Are you or your partner 67 years old, or will you be turning 67 in the period that your leave would be getting paid out?
  

• Income: Would your Centrelink assessable income be above the threshold to receive an age pension?
  

• Assets: Would your Centrelink assessable assets be above the threshold to receive an age pension?

Note: if you are too young for Age Pension, or your current income and assets are already above the asset and income test thresholds, there is one less factor for you to consider. Therefore, your decision should primarily be based on tax, opportunity cost or employer superannuation contributions (each explained later).

However, if you, or your partner are eligible for Age Pension, it can often be beneficial to take the leave as a lump sum prior to applying, so that the regular income payments do not offset the amount of Age Pension you or your partner could otherwise receive via the income test calculation.

However, there may be times when it is better to take the regular payment if you are on the borderline of the asset test.

It's important to do a cost benefit analysis of whether the extra Age Pension you may receive, is more than the extra income tax you may pay (by taking a lump sum). This is a calculation unique to each individual situation, and therefore you may be better of seeking Financial Advice.

Step 2: Calculate the tax effect of each decision

If you take the leave as a lump sum, all of the applicable tax will be added to the financial year it was received. This can be a good or bad thing.

For instance, if you take the leave as a lump sum midway through June, after working the rest of the Financial Year, the lump sum tax is likely to be pretty high.

However, let's say you retired and took all of your remaining leave in July, then there is likely to be less tax as you are not also adding extra employment income to that financial year.

The reason why this decision is important is because Australia operates under a marginal tax rate (rather than flat tax rate) system where the first roughly $20,000 is tax free. This means that it is often better to allocate taxable income (whether its leave entitlements or capital gains taxes on property sales) to years when you are otherwise expecting lower income.

Lastly, making pre-tax contributions into superannuation is also a common strategy when looking to reduce your taxable income as most contributions are taxed at 15% when received by the super fund, which could be lower than your marginal tax rate. It is important to review your contribution cap space and age eligibility to make extra contributions.

Step 3: Consider the Opportunity Cost and Time Value of Money

There's an old saying: " a dollar today is worth more than a dollar tomorrow". This is partly because of the effects of inflation, but also because if you had a dollar today, you could invest it straight away to generate extra returns. For instance, you could put the money into your super or a high interest cash account straight away.

Therefore, if tax and age pension were not considerations, you would always decide to take the funds as early as possible, i.e. in a lump sum manner.

Step 4: Consider employer super contributions on leave entitlements

When your leave is paid as a regular payment, you typically still continue to receive the 12% mandated SCG contributions. However, if you take the payment as a lump sum you may forego these super contributions.

As an example, if your long service leave balance is $20,000, you could receive $2,400 extra super contributions by taking the leave progressively instead of as a lump sum.

Decision time

If it were a mathematical equation, it would look something like this:

Benefit of taking a lump sum = Benefit of time value of money + Potential Extra Age Pension - Potential Extra Income Tax - Potential Extra Super Contributions

If this equation is a positive number, you should take a lump sum, if it is a negative number, you should take a regular payment.

If you need help calculating this and reviewing your wider retirement planning:

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The purpose of this blog is to provide general information only and the contents of this blog do not purport to provide personal financial advice.  We strongly recommend that investors consult a financial adviser prior to making any investment decision. The contents of the our blog does not take into account the investment objectives, financial situation or particular needs of any person and should not be used as the basis for making any financial or other decisions. The information is selective and may not be complete or accurate for your particular purposes and should not be construed as a recommendation to invest in any particular product, investment or security. The information provided on this blog is given in good faith and is believed to be accurate at the time of compilation.