Implementing a transition-to-retirement income stream has been a valuable SMSF strategy for the past decade. Now a new ruling from the ATO has made this approach even more appealing, Craig Day writes.
The strategy of combining a transition-to-retirement (TTR) pension with a salary sacrifice arrangement has been around for some time and has been used by many advisers to maximise clients’ super savings over the last five to 10 years before retirement. However, a recent ATO private binding ruling has the potential to significantly improve the benefits of this strategy by allowing people to reduce tax on their pension payments received between preservation age and age 59.
Background
Under the Income Tax Assessment Act 1997, where a member of a taxed super fund receives a payment from a superannuation income stream between preservation age and age 59, the taxable component of the payment is taxed as either:
- a superannuation income stream benefit – that is, included in assessable income and taxed at their marginal tax rate less a 15 per cent tax offset, or
- a superannuation lump sum benefit – that is, included in assessable income and taxed at their marginal rate less a tax offset that reduces the effective tax rate to either zero or 17 per cent, depending on whether the amount is within the member’s low-rate cap.
Which method applies depends on whether the member has made a valid election, under tax regulation 995-1.03 for the payment not to be taxed as a superannuation income stream benefit. Provided the election is made prior to the payment being made, it will be taxed as a superannuation lump sum benefit, otherwise it will be taxed as a superannuation income stream benefit. Therefore, depending on the member’s marginal tax rate, the level of taxable component included in a payment and how much of the low-rate cap has already been used, a payment from a superannuation income stream could be taxed at different rates, depending on whether it is taxed as a lump sum or income stream benefit.
Table 1
Table 2
Table 3
Can a pension payment be taxed as a lump sum?
While the above rules clearly allow for a payment received due to the commutation of a pension to be taxed as a super lump sum, there was previously uncertainty about whether the rules extend to allow a member to elect to have regular periodic pension payments taxed as superannuation lump sums to take advantage of the low-rate cap. However, in 2013 the ATO released Tax Ruling 2013/5, which states (at paragraph 7) that: “Each periodic payment, in a series of periodic payments, made from a superannuation interest that supports a superannuation income stream is a superannuation income stream benefit unless an election under regulation 995-1.03 of the ITAR (Income Tax Assessment Regulations) 1997 has been made for that payment not to be treated as a superannuation income stream benefit.”
This indicates a member who commenced a superannuation pension between preservation age and age 59 can elect to have normal periodic pension payments taxed as superannuation lump sums to take advantage of their low-rate cap.
The next question is whether a member who commenced a TTR with 100 per cent preserved benefits is able to make the election.
Who can make an election under tax regulation 995-1.03?
Under regulation 995-1.03, a person is able to make an election for a payment from a superannuation income stream to be taxed as a superannuation lump sum where:
- the income stream rules allow for the annual payment amount to be varied, and
- the person made the election before the payment was made.
In this case, a superannuation income stream is defined to include an income stream that is taken to be a pension under regulation 1.06(1) of the Superannuation Industry (Supervision) Regulations, which includes TTR pensions.
Therefore, given that:
- TTR pensions meet the definition of a superannuation income stream, and
- the amount of income payable from a TTR can be varied between the annual minimum and 10 per cent maximum, it appears a member who commenced a TTR with 100 per cent preserved benefits should also be able to make a valid election under tax regulation 995-1.03 to take advantage of their low-rate cap.
The private binding ruling
In December 2015, the ATO issued a private binding ruling that outlined that a 59-year-old taxpayer who had commenced a TTR pension with 100 per cent preserved benefits was able to elect for the annual payment to be taxed as a superannuation lump sum benefit. The taxpayer would not be commuting any part of the pension and would also not be requesting a lump sum payment from the trustee.
As part of the ruling, the ATO also noted that as the client was aged between preservation age and 59, by electing to treat the payment as a superannuation lump sum, they were then able to take advantage of the low-rate cap, which allows the first $195,000 of taxable component to be received tax-free.
January 2016 update
The ATO has updated its website concerning a member being able to make an election to treat a regular periodic pension payment from a TTR as a lump sum benefit for tax purposes. In the update, it confirmed the nature of the payment will not change for superannuation regulatory purposes, that is, the payment will not be treated as a commutation and will count towards the pension minimum and 10 per cent maximum. However, the ATO also took the opportunity to remind trustees of a number of other issues, including:
- if the payment is not a lump sum for superannuation purposes, it cannot be paid by an in-specie asset transfer, and
- electing for a payment to be treated as a super lump sum for income tax purposes may affect the amount of the SMSF’s exempt current pension income for an income year and whether particular fund assets are segregated current pension assets.
The second point is extremely important as any tax savings from a member electing to have a periodic pension payment taxed as a lump sum could be significantly outweighed by the fund potentially having to pay more tax due to a reduction in the level of the fund’s exempt current pension income.
Therefore, before implementing this strategy, clients may wish to consider applying for their own private binding ruling or wait for the ATO to make a public announcement.
Strategy implications
Subject to the ATO confirming that making the election would not impact on the level of the fund’s exempt pension income, the ability for a client to use their low-rate cap to reduce tax on their TTR payments between preservation age and age 59 could substantially improve the benefits of a TTR salary sacrifice strategy.
Case study: Kevin
Kevin is 56 and earns a yearly salary of $100,000 (his only income). He has a super balance in an SMSF of $300,000, all taxable component, and doesn’t currently make any additional voluntary super contributions. Let’s compare:
Not implementing a TTR strategy.
Implementing a TTR strategy and taking a minimum pension payment, which is taxed as an income stream benefit.
Implementing a TTR strategy and taking a minimum pension payment, but making an election for it to be taxed as a superannuation lump sum.
Comparison after one year
A comparison of Kevin’s options after one year is as in Table 1 and 2. The comparison assumes 2015/16 rates and thresholds apply, a superannuation guarantee rate of 9.5 per cent, super balances earn 6 per cent income yearly and all taxable income is at 15 per cent in accumulation phase. Contributions and pension payments are assumed to occur halfway through the financial year. Where a TTR strategy is implemented, it is done in a way that ensures Kevin’s net income remains unchanged. Tax rates include Medicare levy and super pension tax offsets. Making a 995-1.03 election does not impact on the level of the fund’s exempt pension income. We can see that, compared to undertaking the regular TTR strategy, if Kevin instead elects for his pension payments to be taxed as super lump sums, he would be able to salary sacrifice an additional $4721 to super and still end up with the same net level of income in the hand.
The impact on Kevin’s retirement balance at age 60 would then be as in Table 3. Therefore, by electing for his TTR pension payments to be taxed as super lump sums, Kevin could have increased his total super balance by $18,253, compared to a traditional TTR strategy, by age 60. In addition, Kevin would still have $145,629 of his low-rate cap remaining. It is assumed a low-rate threshold of $195,000 for 2015/16 applies and is not indexed.
