SMSF members drawing a greater amount of minimum pension and using a recontribution strategy may be better served in changing the order in which they draw down benefits to maximise their tax-free position and transfer balance cap (TBC).
Smarter SMSF chief executive Aaron Dunn said the standard order for a recontribution strategy was to take the minimum pension amount, which ensures the SMSF is entitled to its tax exemption, and then to take lump sums from the member’s accumulation account to improve the tax exemption ratio of pension assets to total assets.
Following this, Dunn said the third step was to do a partial commutation from the pension, which would create a debit on the member’s TBC to absorb any future amounts, such as death benefits, the member might receive.
Speaking at his firm’s recent 2022 SMSF Day in Sydney, he said it may be worth questioning this order and flipping the second and third steps to avoid cycling money through the fund and impacting the tax-free components.
“If we are going through a recontribution and setting up multiple pensions, but have put the money back into accumulation during that year, and taken above the minimum in that year, the last thing that we want to be doing by this standard order is then taking amounts above the minimum amount that all come out of non-concessional contributions; it’s kind of self-defeating,” he said.
“We may be better off putting the third step second, the second one third because it will allow us to keep drawing out of the pension that has the highest taxable component in it, because the components of the accumulation account at this point in time will have been entirely made up of tax-free money.
“That process is going to depend on the activities that we will do in those particular years as to whether we do want to be taking out of accumulation and subject to tax-free component and then also subject to the components of the income stream.
“What we might want to do is to commute and continue to commute from that pension that has the highest taxable component, and then we will then start new pensions out of that accumulation of money to absorb us back up to that transfer balance cap.”
He said SMSF members would not work through and understand what they have in their pension and accumulation accounts and if they should change the order of drawing down, but emphasised it had to be a prospective decision.
“One of the key requirements for a valid commutation if we are doing the commutation and we want to create a debit on the transit balance account is to follow what the commissioner says in Taxation Ruling 2035,” he said.
“It must be prospective. It must be a revocable election as well. Otherwise, if we do not satisfy the requirements of what is a valid commutation, the amount is not a lump sum but will be treated as a pension and we do not get the debit with that particular strategy.”
