SMSF balances are made up of taxable and non-taxable components. Understanding the workings of these elements can open the way to employ more prudent strategies, writes Tim Miller.
As part of the 2007 reform to simplify superannuation, all member benefits paid since 1 July 2007 were divided into two components: tax-free and taxable. Where an amount is paid, either to a member or beneficiary, or rolled over from a superannuation fund, the components of the benefit payment must mirror the components contained in the total member interest. This means all benefits must be paid on a proportional basis.
A fairly common line of questioning raised is how and when are the components calculated and is there any way of improving the balance between the two. These questions are just as important in the post-1 July 2017 super reform as they were back in 2007.
Historical components
For anyone who held money in superannuation prior to 1 July 2007, their superannuation benefits were often composed of up to as many as seven components, the most common of which were:
- post-30 June 1983 component,
- pre-1 July 1983 component, and
- undeducted contributions.
Tax-free component
Under the 2007 reform, the tax-free component was calculated as a fixed-dollar amount as at 1 July 2007, and this was referred to as the ‘crystallised segment’.The crystallised segment was initially calculated as the sum of the following amounts:
- pre-1 July 1983 component (if any),
- undeducted contributions (if any),
- capital gains tax (CGT)-exempt component (if any),
- post-June 1994 invalidity component (if any), and
- •concessional component (if any).
The tax-free amount will continue to increase over time by the amount of:
- any new superannuation contributions made in respect of the member for which no tax deduction is received, such as non-concessional contributions,
- small business CGT contributions and structured settlement/personal injury contributions, plus
- the tax-free component of any amounts rolled over, or transferred, to the fund.
These amounts received from 1 July 2007 onwards are referred to as the contribution segment.
Taxable component
The taxable component is simply calculated as the difference between the total superannuation interest and the tax-free component. The taxable component can comprise a taxed element and an untaxed element. There are no legitimate circumstances where an SMSF will carry an untaxed element, however, there are circumstances, such as paying a death benefit lump sum to non-tax dependants, where an untaxed element calculation may be required.
Separate interests within an SMSF
When contemplating the tax-free and taxable components, it needs to be understood that members of an SMSF only have one superannuation interest until such time as they commence a pension in accordance with the Superannuation Industry (Supervision) (SIS) Act. Each pension commenced gives rise to a new separate interest.Nothing in the recent superannuation reform alters this fact, yet the introduction of some new terminology will undoubtedly create some confusion and this confusion has the potential of creating issues with regard to proportioning of benefits and allocation of income.
Individuals may choose to operate multiple SMSF pensions for tax and estate planning purposes.
New terminology
The introduction of the concepts of the ‘retirement phase’ and ‘accumulation phase’ are specific to a fund’s entitlement to claiming exempt income – they are not specific to determine what is and is not a pension. This is an important distinction as different proportioning rules apply to benefits paid from a member’s accumulation interest, of which SMSF members can only have one, versus benefits paid from any pension interests the member may have, accepting that a member may have multiple pension interests.
Calculating the proportions
As stated upfront, a superannuation benefit is taken to include the tax-free and taxable components in the same proportions that the components make up the total value of the superannuation interest.A fund is not required to continually calculate the tax-free and taxable proportions, rather they are calculated upon the triggering of certain events, specifically paying a lump sum and commencing a pension.
Paying a lump sum
Every time a lump sum benefit is paid from an accumulation interest, the tax-free and taxable proportions must be calculated, based on the value of the interest. The fund will firstly determine the tax-free amount by adding the crystallised segment to the contribution segment; the balance of the interest will be taxable. These two amounts are then represented as proportional percentages of the interest.These percentage factors are then applied to the lump sum.
Lump sum example
David, 60, has an accumulation interest valued at $1 million, which is comprised of an $800,000 taxable component and a $200,000 tax-free component.The proportioning split is determined as a percentage of the total interest, which is 80 per cent taxable component and 20 per cent tax-free component.
If David takes a superannuation lump sum benefit of $20,000, the split will be based on these percentages: = $16,000 taxable (80 per cent) and $4000 tax-free (20 per cent).
In an accumulation interest all growth is attributable to the taxable component, similarly all losses will be subtracted from the taxable component. Therefore, each time a lump sum is taken from an accumulation interest, the proportions have to be recalculated based on the reality that the fund will have been subjected to positive or negative returns.
Commencing a pension
Unlike lump sums from an accumulation interest, pension interests only have their components calculated once, at commencement. With pension interests, all growth, and losses, are proportional based on these component percentages determined at commencement.The same initial calculation applies as with an accumulation lump sum withdrawal, however, once the proportions are set they can’t be changed and the commencement percentages apply to all pension payments, earnings and commutations from the pension interest.
In David’s example, every pension payment would be split 80 per cent to 20 per cent as would any full or partial commutation from the pension.
Investment returns
As highlighted above, there is an important distinction between accumulation and pension interests and how investment returns are treated. This can have an impact on a member’s decision to commence or maintain a pension, particularly in light of the introduction of the transfer balance cap, which does not give consideration to investment returns.Transition to retirement – pension or accumulation?
What has created an element of confusion is that from 1 July 2017 a transition-to-retirement income stream (TRIS) is considered to be in the accumulation phase and subject to taxation at the fund level. Additionally, the law has been amended to indicate a TRIS will be considered to be in retirement phase from the member’s 65th birthday or at such time that the member satisfies one of the following conditions of release and notifies the trustees of their fund that the condition has been met:
- retirement,
- permanent Incapacity, or
- terminal illness.
Of course, the movement from accumulation phase to retirement phase is prospective, so will not occur until the member notification is received by the trustee, which is always a strange phenomenon in the case of an SMSF trustee.
Interest v phase
Historically we had made the connection that interests and phases were linked, which in theory they were, except superannuation phases, that is, accumulation and pension, weren’t previously a real thing, they were just a concept designed to identify the life cycle of fund membership. Now we have to understand that an interest is still created when a pension is commenced, however, that interest may be taxed in the accumulation environment until it meets certain conditions.Once you can accept that situation, then you will see a TRIS can still provide some strategic advantages to members who have attained preservation age as existing benefits can be isolated from future contributions, meaning estate planning strategies that previously relied on multiple income streams can still be commenced during the transition-to-retirement phase, even if it’s not really a phase.
Estate planning
Understanding the concept of single versus multiple interests and proportioning can provide significant benefits for estate planning purposes. Lump sum death benefits are not assessable when paid to a tax dependant, such as a spouse or a child under the age of 18, however, the taxable component will be taxed at 15 per cent, plus Medicare, when paid to a non-tax dependant, such as an adult child.By establishing more than one pension interest within an SMSF, a member may be able to distribute benefits upon their death in a more tax-effective manner. This will not happen automatically and given all benefits are paid as a proportion that reflects the entire interest, it may not be possible for members to achieve their ultimate objective, however, with some planning they can provide some benefit.
Re-contribution strategy
One of the most effective ways to achieve a desirable tax outcome is via a re-contribution strategy. The re-contribution strategy works best once a member commences one or more pensions as otherwise the member is just re-contributing to an accumulation interest, which will have some tax effect but the contribution value is at risk of being diminished by future investment returns.The re-contribution strategy is generally only possible if a member has unrestricted non-preserved benefits enabling them to take a lump sum, hence why pension commencements are an opportune time to consider them. However, given there is no upper limit to how much a TRIS can be commenced for prior to moving to the retirement phase, the 10 per cent maximum withdrawal can also be beneficial.
Of course, re-contribution strategies are going to be limited by a member’s total superannuation balance and their age so are most effective for members under the age of 65 with less than $1.4 million in total super.
Understanding proportioning
It’s important trustees and members understand how proportioning works if they want to undertake re-contribution strategies for estate planning purposes. Once a member turns 65, their ability to contribute is linked to working, so is often restricted. Likewise, the ability for someone to meet a condition of release and commence a pension prior to the age of 65 is not always available.The result is that for some there is limited ability to change the proportions within a fund.
