The pre-retirement drawdown dilemma

SuperGuardian education manager

SMSF administrator SuperGuardian has appointed a well-known sector educator and consultant Tim Miller to a new education manager role with the Adelaide based firm.

Transition-to-retirement pension strategies have been significantly disrupted by this year’s proposed budget changes.

Tim Miller examines their viability after 1 July 2017.Transition-to-retirement (TTR) pensions have for a long time come under budget speculation and that speculation has come to fruition, although not with their complete demise as has often been predicted. From 1 July 2017, TTR pensions will no longer be entitled to the exempt current pension income (ECPI) deduction. This begs the questions: will TTR pensions count towards the $1.6 million transfer balance cap and do they serve any purpose? If, as most assume, they don’t count towards the cap, we need to review existing TTR strategies and determine their viability now and beyond 2017.

Current TTR strategies and their future

Sometimes when you poke a bear it will react and so it goes when you promote legislative loopholes to obtain unintended taxation benefits. The 2015/16 TTR strategy of drawing an ‘income’ from a TTR pension and then making a taxation election to treat the benefit as a lump sum, not an income stream, is one of those instances where the lack of cohesion between compliance legislation and taxation legislation created a unique opportunity for a small percentage of the current superannuation population, but its continuation would raise concerns about the purpose versus use of superannuation proceeds. The ATO when allowing this strategy said this may have ECPI consequences and how right it was.

How the strategy works

As we know, the ATO issued a private binding ruling to an SMSF indicating the fund could treat the annual withdrawal(s) as a superannuation lump sum subject to the superannuation lump sum low-rate threshold, rather than treat the income as a superannuation income stream benefit subject to the member’s marginal tax rate less the 15 per cent rebate. The result for members aged under 60 but above preservation age is a significant tax savings.


Fiona is 57 and has an SMSF with $1 million, all taxable and all preserved. She also works full-time and is earning $100,000 a year.

Fiona commences a TTR pension for the full value of her account balance. This requires Fiona to draw an income between $40,000 and $100,000.

As this withdrawal is from an interest that supports an income stream, it is considered to be a superannuation income stream benefit for the purposes of tax unless prior to making the withdrawal Fiona makes an election to treat the withdrawal as a superannuation lump sum. Note, Fiona does not request to partially commute the pension. She indicates she wishes to draw her maximum pension for the year and the amount she elects to be treated as a superannuation lump sum for taxation purposes is $100,000.

In 2015/16 and 2016/17 the low-rate threshold is $195,000, so as Fiona has not previously taken any lump sums, the total of her withdrawal is tax-free. Had we assumed Fiona’s drawings were income stream benefits, then the majority of her income would have been taxed between 22 per cent and 30 per cent allowing for rebates and given her other income. That is a fairly significant tax saving.

Now we assume Fiona repeats the exercise in the 2017 financial year, her account balance has dropped to $900,000, her maximum is $90,000 and even without indexation to the low-rate cap, she is comfortably receiving this payment without further tax liability.

Of course, if we don’t take this example to the extreme, but rather to an income level represented somewhere between her minimum and maximum, Fiona could use this strategy successfully with a salary sacrifice strategy and maintain a certain level of capital within her SMSF while receiving the tax benefit on the outside. More on salary sacrifice below.

When two laws collide – someone intervenes

History shows us that the income tax law in both its 1936 and 1997 versions has always had trouble conforming with the Superannuation Industry (Supervision) (SIS) Act 1993, either due to conflicting definitions, term differentials or absolute silence, and this is regularly evident with pensions, or perhaps ‘income streams’. There is no doubt the law is open for interpretation and as a resource we can always approach those tasked with the powers to administer the law for their interpretation, however, in doing so we have to be ready to accept their answer.

The ATO’s original position was that in the context of lump sum versus pension you could only elect the payment as a lump sum if it was the subject of a commutation, as you were effectively exercising your right to exchange some of your future entitlement to receive a pension for that lump sum. A TTR pension without unrestricted non-preserved benefits did not have a right to lump sum commutations.

It would seem the government agrees with this original sentiment and changes will be introduced to revert to legislative provisions that reflect this.

We assume these changes will take place from 1 July 2017, but perhaps it also means the ATO will use its interpretive powers to deny the election for 2016/17 as well. Either way, the strategy has a limited shelf life.

Budget or no budget – know your TTR strategy

Given the attention the above strategy has received and how it has been promoted, you’d better get in fast. There will no doubt be a groundswell of clients in the 56 to 59 age bracket contemplating using the strategy. Inevitably, as with all strategies, there will be those who receive incorrect advice or do their own research and don’t seek further advice and attempt to undertake this strategy. If clients follow the process to the letter and draw between 4 per cent and 10 per cent, then theoretically there is no problem, but what if they don’t? What if they read this strategy in conjunction with more popular TTR pension strategies? Let’s look at those strategies, the traps of multiple strategies and the future of TTR.

Existing TTR strategies – SIS approved

An acceptable strategy is where trustees apply the SIS Regulations in conjunction with the tax rules to allow a partial commutation of a TTR account-based pension, providing a member with access to any unused unrestricted non-preserved benefits that may exist within the pension. SMSF Determination 2014/1 provides the tax commissioner’s position that this is allowable. The law recognises this lump sum, also subject to the income tax election, will count towards the minimum pension requirement, but does not count towards the maximum, so conceivably a member can draw their unrestricted non-preserved benefits as an elected lump sum via a partial commutation and subsequently withdraw their maximum pension entitlement. This strategy gives the impression the member has taken over their maximum, but this is not the case.

How does this strategy work?

Let’s revisit Fiona’s position. Everything is the same, except Fiona has $400,000 of unrestricted non-preserved benefits existing from previously satisfying a condition of release. She goes down the same path of commencing a singular pension from her SMSF, but given $600,000 of her benefits are preserved, the pension is considered a TTR pension.

Fiona wants to draw down her maximum of $100,000, but prior to doing so determines she actually needs a further $50,000 to replace her car. She has multiple options available to her, one being that she could elect to take the entire amount as a partial commutation that will a) satisfy her minimum pension requirement, but b) not count towards her maximum. Alternatively she could take part of the benefit as an income stream and the balance as a lump sum.

Either way, she has options. Based on what we can take from the budget, this strategy will still be applicable after 30 June 2017.

Two strategies, one wrong choice

There is clarity between strategies and one is clearly supported by the law governing superannuation funds, whereas the other is relying on a current lack of cohesion between two pieces of legislation. The real drama commences when clients don’t understand the nuances between the two and take more than their maximum from their preserved pension. While it is easy to say it won’t happen, we can all rely on the reality that in all probability it will happen or already has happened. What are the ramifications then?

Pension cessation

A pension ceases when a fund fails to comply with the SIS Regulation Pension Standards. When a pension ceases, the consequences can be detrimental to SMSF trustees and members.

Failure to meet pension standards

A fund that does not ensure the pension standards are met in a year is deemed not to have paid a pension at all for that year. Any pension is effectively ceased at the start of the year and any payment is considered to be a lump sum payment. That’s what we wanted, right? Wrong.

The risk for a TTR pension is that drawing a lump sum from a pension that no longer exists is a breach of the payment standards and the payments will be taxed as normal income, plus a possibility of further penalties. Anything else?

Lose exempt current pension income deduction

While the fund has a liability to pay a pension, it is entitled to claim an exempt current pension income deduction. By failing to meet the pension standards, the fund does not have a pension liability and so therefore is not entitled to the deduction, which means the income of the fund is taxable.

Okay, so this will effectively become a moot point due to the proposal to remove the exempt pension income deduction from TTR pensions, however, given that won’t apply until 1 July 2017, funds will want to get maximum value from the deduction until then.

That in itself presents strategic opportunities for 2016/17. Here is an opportunity to review the fund’s investment strategy and perhaps crystallise any capital gains while there isn’t any tax to pay.

Other TTR pension strategies

The final common SMSF TTR strategy is the combined salary sacrifice/TTR strategy. The reduction in the concessional contribution caps plus the removal of the exempt pension income deduction will reduce the effectiveness of this strategy for those in the lower marginal tax brackets, however, it should not be discounted entirely as tax-effective investments will continue to provide SMSFs with a lower than 15 per cent tax rate, so savings, albeit smaller, are still achievable.

The end of TTR?

Does this mark the end for TTR? Quite the contrary, the budget may very well restore TTR to its originally intended purpose, to allow those transitioning toward retirement to reduce their working hours by replacing employment income with a superannuation income stream. Sure it may not be as tax effective as it once was, but it hasn’t been abolished as once was thought might happen.

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