A few new ATO rulings and determinations should encourage SMSF members to review their pension arrangements to see if a multiple pension strategy is more prudent, writes Tim Miller.
On 31 July 2013, the ATO released Taxation Ruling (TR) 2013/5 “Income tax: when a superannuation income stream commences and ceases” and SMSF Determination (SMSFD) 2013/2, which separately dealt with the concept of partial commutations counting towards the minimum pension requirement for an account-based pension, excluding transition-to-retirement pensions. In November 2014, the ATO released SMSFD 2014/1, which provided its view on partial commutations from transition-to-retirement pensions.
The ruling and determinations gave us the opportunity to review existing pension arrangements to determine whether they are providing the best outcomes for clients. The question is have we taken that time and reviewed existing arrangements or used the ATO documents as a guidance when advising a client to commence a pension?
One question that should always be at the top of our mind is how many pensions should our client have?
Highlights of the ATO ruling
The key concepts the ruling addressed are when a pension commences and ceases.
To be considered a pension, the rules must not allow the capital supporting the pension to be added to by way of contribution or rollover after commencement. Therefore, the first thing to be considered by a member wishing to commence a pension is whether or not all the necessary monies have been added to the fund by way of rollover or contribution.
What is important about the timing of rollovers and contributions is the concept of pension interests. As we know, a member of an SMSF can have more than one pension interest and once a pension commences it is always to be treated as a separate superannuation interest.
The use of multiple pension interests is generally determined by the needs of the members, often with reference to estate planning.
Tax-free and taxable components calculated at the commencement of a pension apply to all pension payments and superannuation lump sums from that interest, therefore if a member is looking to direct particular benefits to particular beneficiaries, then the use of multiple interests may be an appropriate way to achieve this.
Dave, 64, has a $500,000 accumulation balance which is 100 per cent taxable. He has the ability to contribute up to $540,000 as a non-concessional contribution. As part of Dave’s estate planning, he wants to split his superannuation benefits between his second wife and his adult child from his first marriage.
Step 1 – Dave commences a pension for $500,000 (100 per cent taxable) – reversionary
Step 2 – Dave makes contribution of $500,000
Step 3 – Dave starts a second pension for $500,000 (100 per cent tax-free)
Dave makes the first pension reversionary to his wife and the second pension is subject to a binding death benefit nomination to his child in accordance with the trust deed and pension contract.
The ATO has categorised five events when a pension ceases:
- the capital of the pension is exhausted,
- the pension is fully commuted,
- a fund fails to comply with the Superannuation Industry (Supervision) (SIS) Regulations payment standards,
- death with no automatic reversion, and
- in accordance with SIS payment standards.
The ATO ruling differentiates between full and partial commutations, but both events have consequences that strategies can be built around.
Why commute a pension?
These days people can stop and start pensions as regularly as they like once attaining preservation age. It therefore begs the question: why would someone commute a pension?
Let’s look at some reasons:
- roll back to accumulation – capital preservation,
- commence a new pension – add additional contributions, and
- wind up fund or transfer to another fund.
The ramifications of commuting the pension are clearly that the SMSF will lose its exempt pension income deduction in the future, so as a result tax will apply on the sale and income of assets beyond the commutation. Possibly a more significant ramification from a tax planning point of view is that a member’s tax-free and taxable proportions will no longer be fixed once a pension ceases, other than on death.
If we accept the purpose of the commutation is to revert to accumulation for capital preservation, then the expectation is that the tax status will change, so specific planning is not necessary, unless the sale of a significant asset with large gains is looming.
Commute and repurchase
If a member has commenced a pension and makes subsequent contributions to their SMSF, they can elect to refresh their pension by commuting the existing pension and commencing a new pension, or they can run with multiple pensions. What the member needs to be aware of are the following issues.
Pro-rata minimum requirement to date of commutation must be paid
If a member elects to commute their pension they must pro rata the minimum payment up to and including the day of the commutation, this means if a member elects to commute their pension on 1 July there must be one day of pro-rata pension paid.
Pro-rata minimum from date of commencement must be met
If a member commences a new pension with the additional contribution, then in addition to the pro-rata requirement on the pension they have commuted, they have an obligation to pay the pro-rata minimum pension for the number of days from commencement until 30 June. Of course, if a member commences a pension on or after 1 June in a financial year, then no minimum pension is required for that year for the new pension, but the previously commuted pension still needs to pay its pro-rata amount.
Similarly to the concept of whether multiple pensions should be commenced to isolate concessional contributions from non-concessional contributions, the pro-rata requirements should be considered when determining whether to stop and restart a pension or whether to run multiple pensions. If a member elects to run a new pension while retaining an existing pension, then they will still be required to pay the pension for the full year on the existing pension. However, the pro rata for the new pension is only on the new capital amount, not the combined capital amount. The following example highlights this situation.
Dave, 64, has a $500,000 account-based pension, from which he currently draws an amount of $20,000 annually in December.Due to the sale of an investment property, Dave contributes a $540,000 non-concessional contribution on 31 December. At the time of the contribution, he requests the trustees commute his existing pension and commence a new pension, effective 1 January. On the assumption there have been no earnings in the fund for the year, the new pension commencement value is $1.02 million. Based on the new pension, the pro-rata pension for six months is $20,230. If Dave commenced a pension for just the $540,000, the minimum would have been $10,710.
When we combine these two scenarios with the $20,000 already drawn, we get the following results:
Two pension strategy = $30,710 (keeps the existing pension in place)
One pension strategy = $40,230
Dave has drawn about $10,000 more than he is actually required and has used his three-year bring-forward limit so he is unable to put $10,000 back in unless he has scope under his concessional contribution limit.
To suggest Dave has received poor advice may not fully appreciate Dave’s position and he might want the extra drawing because at least it has come from his taxable pension. The point of the example is to highlight that Dave has options.
The ruling highlights that partial commutations do not result in pensions ceasing. A lump sum from a partial commutation will count towards the minimum pension requirement and it can be an in-specie payment. This is confirmed in SMSFD 2013/2 and 2014/1.
If a member wants to take a benefit from their pension and the amount is not to be treated as a pension payment, we know the member must make an election under regulation 995-1.03(b) of the Income Tax Assessment Regulations 1997 that the payment is not a superannuation income stream benefit.
There are certain circumstances where it might be more appropriate for a member to treat a benefit as a lump sum rather than a pension. For a member aged between preservation age and 60, the taxable portion of their pension will be assessable income entitled to a 15 per cent rebate. At the same time, if a member draws a superannuation lump sum, they are entitled to a lump sum low-rate threshold, which was $185,000 for the 2015 financial year and $195,000 for 2016. Each individual can receive up to the threshold of taxable benefit taxed at 0 per cent. Amounts in excess are taxed at 15 per cent. This makes lump sums attractive for those in receipt of a pension who have other income or their pension incurs a higher rate of tax subject to the member having unrestricted non-preserved benefits.
Multiple v single interests
Some members aged between preservation age and 65 will have unrestricted non-preserved benefits and preserved benefits. The SIS payment standards require a member’s benefit to be paid in the following order:
- unrestricted non-preserved,
- restricted non-preserved, and
This means prior to satisfying a further condition of release, a member has options. They can either start one transition-to-retirement pension with their entire balance or alternatively they could pay two pensions, one with unrestricted benefits and one transition to retirement.
Circumstances may dictate which is best. (See examples below.)
Summary of pension issues
In conclusion, there are many strategies available for account-based pensions that were been in existence prior to the ATO releasing the ruling and determinations, but they should be reviewed as a result of the publications. Of particular interest is running multiple pensions and the effect they can have on estate planning, satisfying minimum pension obligations and reducing personal tax liabilities. As is always the case, an individual’s circumstances should dictate the strategy options.
Example 1 – Member under 60
Paying one pension combining all benefits may be particularly useful if they have sufficient unrestricted benefits.
Dave has $500,000 in unrestricted non-preserved and $500,000 in preserved benefits.
If Dave has a single pension strategy, it would allow him to take up to $40,000 as a combination of lump sum and pension using the low-rate threshold, potentially reducing his personal tax liability.
If Dave had a two pension strategy, it would mean he could only use that strategy to reduce tax on the income requirements for the unrestricted non-preserved pension. He would pay marginal tax less a 15 per cent rebate on the pension withdrawals.
Example 2 – Member aged 60 but under 65
Let’s assume Dave at 60 is still gainfully employed. He may wish to commence two pensions: one pension with unrestricted non-preserved benefits of $500,000 and one transition-to-retirement pension for the other $500,000.If Dave draws his minimum each year, then under a two-pension strategy he will still have $420,000 in unrestricted non-preserved benefits at age 64 (excluding earnings).
If, however, Dave had a one-pension strategy, it means he will have $260,000 in unrestricted non-preserved benefits at age 64 (inclusive of earnings).
That’s a significant estate planning difference if Dave were to implement a re-contribution strategy prior to the age of 65 with his unrestricted benefits.