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Strategy

A new strategic revolution

The super reforms have paved the way for an exciting new era for advisers providing innovative strategies for their clients, writes Grant Abbott.

The new laws change the SMSF game

If you know me, you know my focus with an SMSF is always on strategy – not investments, but real, honest-to-goodness strategy. I have seen too many SMSF businesses that focused on investments go to the wall in 2000 and 2008 with a downturn in the markets – not so strategists. However, strategy without a goal is an impossible task and really a waste of time. After all, why would you put in place a transition-to-retirement income stream (TRIS) for a person who is over 65 and can commence an account-based pension? By the way, that is a trick question. There are in fact three great strategies when a TRIS is better than an account-based pension for someone over 65.But back to goal setting and SMSF strategies. Like most things and tasks in life, there clearly needs to be an end point that both the adviser and client can work toward with the best tools and strategies available. Now from all my experience working with trustees and research undertaken by the SMSF Members Association, the end game of an SMSF for most members is to provide a secure, safe and consistent income stream in retirement and if possible pass as much on as possible on death. Sounds smart, reasonable, practical and you would expect there would be a huge SMSF member demand for strategies dealing with retirement income and estate planning, variable investment, maximising super and minimising tax.

Well not so. Quite simply for the past 10 years there has been a strategy drought and for that we can blame former treasurer Peter Costello and his Simpler Super rules in 2007. Costello introduced laws that made a complex super beast, which had benefit limits, heavy penalty taxation for breaching those limits and complex laws on the taxation of benefits, simple. So simple that establishing and maintaining an SMSF became an easy four-step process:

  1. Set up the SMSF
  2. Contribute
  3. Invest
  4. Pay a pension.

So when a member got to the pension stage in the fund there was little else to do except monitor the fund’s investment strategies and keep on top of compliance. A real set-and-forget strategy. It also limited the differences between a retail or industry super fund compared to an SMSF.

No more set and forget: a big thanks to Treasurer Scott Morrison

Thanks to Treasurer Scott Morrison’s 2016 budget, SMSFs and strategy have changed quite dramatically. At first glance I was dismayed for all trustees, and myself personally, but as an adviser was happy to get complexity back into the system. Morrison changed SMSFs quite dramatically with a de facto reasonable benefit limit that has now brought a whole new raft of strategies for SMSFs at the top end of the tree. Let’s have a look at the new strategic SMSF post 1 July 2017 for those with sizeable SMSFs.

SMSF pensions more than $1.6 million

From 1 July 2017, any member of an SMSF or superannuation fund with assets of more than $1.6 million in their private pension account, generally an account-based pension, will need to reduce that balance to $1.6 million. Failure to do so will result in the tax commissioner issuing a forced commutation of the excess amount above the $1.6 million – essentially requiring a withdrawal from the private pension account. Apart from tax penalties if the excess pension is not commuted within the time frame provided by the commissioner, the fund stands to lose its entire tax-exempt status – a tough proposition.So what should a pension member with assets over $1.6 million do and from recent ATO statistics there are tens of thousands of SMSF members affected.

Let’s look at Gary Smith, aged 64, who has $2 million in his account-based pension on 1 July 2017. This means he has an excess of $400,000. Gary decides to commute the $400,000, that is, turn it into a lump sum and transfer, or what I call roll back, the pension to the accumulation side of his fund. This is one of the allowed commutation strategies in addition to the withdrawal of the excess from superannuation completely.

Importantly, the consequences of the rollback are:

The bad: Loss of tax-exempt status: Income and capital gains used to back a private pension, no matter what amount or size, are all exempt from tax.

However, income and capital gains (which are entitled to a 33.3 per cent discount if the asset is held for more than a year) in a member’s accumulation account are subject to tax at a rate of 15 per cent.

The good: No drawdown: One of the requirements of a pension is that a minimum amount must be drawn down from the pension each year. For a pension member under 65, the minimum is 4 per cent, so for Gary that would have been $80,000 if his pension balance was $2 million on 1 July 2016.

So under the new pension transfer balance laws come 1 July 2017, Gary will be forced to transfer $400,000 into his accumulation account. However, there is no requirement for him to draw down on this amount, but any income and capital gains will be taxed within the fund. Importantly, if Gary withdraws a lump sum from his accumulation account, it will be tax-free in his hands as lump sums and pensions for a member of an SMSF are tax-free once they are over 60.

Post 1 July 2017 for his continuing pension, Gary will be required to draw down 4 per cent of $1.6 million, or $64,000, for the 2018 income year. Now a couple of things to note for Gary. Firstly, Gary will be unable to make any further contributions into superannuation as he has reached his pension limit.

Secondly, and I think strategically, if his pension account balance grows wildly post the 1 July 2017 testing for a current pension, as it has been tested once it will not be tested again.

The new SMSF estate planning: If Gary’s pension account balance provides him with enough income to live on each and every year, then what is the purpose of his accumulation account? This question has never been asked before because the old rules simply required the set-and-forget pension. But under the new Morrison changes, the accumulation account, which may never be drawn upon in Gary’s life, will be held over for estate planning purposes to pass onto his spouse, children, financial dependants or legal estate for distribution by his executor. What he’s going to do with it means strategic work. Gary doesn’t want a complete mess up like the Katz v Grossman [2005] NSWSC 934 case, where a brother and sister fight a nasty SMSF estate planning battle.

SMSF accounts now in accumulation

From 1 July 2017, a member of a superannuation fund will be unable to commence a pension account with an account balance of more than $1.6 million. As with Gary, if they commence a pension, or one or more pensions, with account balances of $1.6 million, these can increase their size post assessment date with no negative effect. However, they cannot commence a pension with a greater amount. It means any amount greater than the $1.6 million will be left in the member’s accumulation account and subject to the 15 per cent tax, but with no drawdown requirements.

What that means for trustees

Up until 2017, subject to the contribution and borrowing laws, the smarter SMSF members sought to maximise the amount of assets in their fund, particularly the closer they were to retirement. For example, people transferred buildings they owned into their SMSF, using a mix of contributions and borrowings so that income received on the building was ultimately tax-free when part of the member’s pension. But what now?Well the rules have changed and for high-growth assets and where borrowings are used, SMSF life isn’t that simple anymore. Take commercial real estate in excess of $1.6 million for 50-year-old members. Here we have a problem – do we want the excess inside of the fund in an accumulation account or perhaps in a family trust so that there is a joint venture with the member’s SMSF? I hate to be the bearer of bad tidings, but SMSFs are not the only solution anymore.

Only modelling and a strategic adviser can solve that problem and long term it will have, among others, the following impacts:

  • ongoing tax in the fund in the accumulation account versus using tax streaming and splitting rules for a trust for distributions to other members of a family,
  • estate planning as any sale or transfer in specie of the property on the death of the member, if necessary, will be subject to tax as a disposal by the trustee of the fund on the SMSF’s accumulation side compared to no disposal in a family trust, and
  • if the proceeds on death are taxable components, then they are taxed at 15 per cent in the hands of a non-tax dependant – an adult child.

As can be seen there is now a lot going on so that tax and superannuation planning need ongoing review. And the previous desire to put as much as possible into tax-advantaged super for high-income earners and those with high-value assets (which could be transferred into an SMSF) is now lessened and complicated with the need to use a family trust.

This also applies for Gary above. Is he really better off transferring the excess $400,000 back into the accumulation side of his SMSF or perhaps he should take it out and invest via a family trust? Again good tax, estate planning and superannuation modelling is crucial.

Some important SMSF strategic issues

As I mentioned earlier, a holistic family adviser who uses family SMSFs and family trusts now has a lot of strategic work to do. And with the next generations coming through with significant superannuation balances, courtesy of a lifetime of superannuation guarantee contributions, the pension transfer balance issue will be a strategic issue for decades to come.So here are some high-level issues that are crucial under the new SMSF paradigm.

Good SMSF and tax advice

By now you would have realised, whether a potential SMSF member, existing SMSF member or professional working in this field, that strategy is fundamental to a great, long-lasting and living SMSF. More importantly, the pension transfer balance rules, briefly discussed above, have made a significant impact on tax and superannuation strategy plus they have a big impact on estate planning. So providing great licensed SMSF and tax advice is a real benefit.

Real-time member accounts

By 30 June 2017, the amount to be subjected to a pension rollback or transferred into a family trust is to be determined. As such, the trustee of the fund must ensure they have accurate member accounts to deliver member pension account figures to the ATO by no later than 30 June so that the pension rollback can be completed successfully. It is going to be an ongoing necessity that real-time member accounts using online SMSF accounting systems with feeds into various investment databases are the norm for SMSF trustees, not the exception.

Trust deed and compliance documentation

The importance of the SMSF trust deed and its governing rules, including the documentation around commuting any pension, commencing any pension, making underlying investments, creating an SMSF will or binding death benefit nomination, has taken on greater significance. The 30 June 2017 set of steps for Gary with his $2 million pension is just as complex and more vital given the penalties that may apply.Importantly, it is highly recommended the trust deed for Gary’s fund be reviewed and probably, given the breadth of changes to the superannuation laws, be upgraded in total. For example, there would be a possible disaster if his fund’s trust deed only allowed the payment of pensions and not lump sums. What would Gary do on 1 July 2017 with the excess and how would this restrictive term in the trust deed impact on the strategies we have reviewed above?

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