A common query we receive is: How does the proportioning rule apply and how do you calculate the tax-free and taxable components in a superannuation benefit? This article aims to assist you in understanding the fundamentals of this rule.
As a starting point, think of the proportioning rule as a sort of integrity measure that prevents the ‘cherry-picking’ of the tax-free and taxable components when a payment is made from superannuation. At its core, the proportioning rule provides that the tax-free and taxable components of a benefit are taken to be paid in the same proportion as the tax-free and taxable components of the member’s interest from which the benefit came.
Defining key terms
In order to fully understand the proportioning rule, the meaning of the following terms used in section 307-125 of the Income Tax Assessment Act (ITAA) 1997 need to be defined: superannuation income stream, superannuation interest, superannuation benefit, tax-free component and taxable component.
Please note these terms can have different meanings in other legislation. We have primarily focused on the definitions of the terms used in section 307-125 of the ITAA 1997 from a taxation perspective and, where relevant, we will also discuss each term’s meaning in superannuation law.
Superannuation income stream
Broadly, the term superannuation income stream in the ITAA 1997 means “a pension for the purposes of the Superannuation Industry (Supervision) (SIS) Act 1993 (Cth) in accordance with subregulation 1.06(1) of the Superannuation Industry (Supervision) Regulations 1994 (Cth)”. For ease of reference, in this article we will use the term pension, which is the term used under the SIS Act, to also refer to superannuation income streams.
Superannuation interest
The term superannuation interest is a tax concept in the ITAA 1997 and essentially refers to either a member’s accumulation or pension interests. More technically, the ITAA 1997 provides that every amount, benefit or entitlement that a member holds in an SMSF is to be treated as one super interest in the superannuation. For reference, most SMSF members only have one interest in an SMSF, that is, their accumulation interest.
However, this definition can become tricky. For instance, an amount that supports a pension is treated as a separate superannuation interest — meaning each pension gives rise to a separate super interest. Essentially, each SMSF member will have one interest per pension and one accumulation interest.
Generally, each superannuation interest of a member in a super fund consists of the tax-free and taxable components (although in some cases, the proportioning rules do not apply where one component may be nil and the other 100 per cent).
Superannuation benefit
The term superannuation benefit means a payment from a super fund to a member (this refers to payments from a super fund to the member in the form of a lump sum or pension payments).
Tax-free component
The tax-free component includes the contributions segment and the crystallised segment. The contributions segment typically includes all contributions made after 30 June 2007 that have not been, and will not be, included in your fund’s assessable income.
The contributions segment is made up of what is commonly known as non concessional contributions (and also includes the capital gains tax-exempt component, superannuation co-contribution benefits and contribution splitting benefits), whereas the crystallised segment broadly includes numerous tax-free components that existed prior to 30 June 2007 and are becoming increasingly uncommon.
Taxable component
The taxable component is broadly the total value of the member’s superannuation interest less the value of the tax-free component. Contributions that would form part of the taxable component are generally amounts included in the assessable income of the fund. Principally, the taxable component consists of concessional contributions and earnings in addition to capital appreciation from investments in the fund.
Determining the tax-free and taxable components
The value of the superannuation interest and the amount of tax-free and taxable components of the member’s interest are calculated as follows:
- Determine whether the benefit is a lump sum or a pension.
- Work out the total value of the superannuation interest and the proportion of tax-free and taxable components as at the applicable time, which means:
- if the benefit is a lump sum — just before the benefit is paid, or
- if the benefit is a pension — on the date the pension commences. (In other words, you lock in the proportion of the tax-free and taxable components on the date the pension commences, and future growth and earnings are shared proportionally between these components).
- Apply the same proportions to the amount of benefit paid (this part is the essence of the proportioning rule).
Implications of the proportioning rule
Proportioning rule when a pension is commenced
In an accumulation interest, the tax-free component is broadly the total of the static amount (that is, the contributions and crystallised segments), whereas the taxable component can change every day as the investments supporting the superannuation interest fluctuate with investment markets and earnings (or losses) accrue in some cases on a daily basis.
However, when a pension is commenced with a certain proportion of a tax-free component and the pension assets increase over time, the tax-free component will effectively grow. This is because at the time of paying pension benefits, the proportioning rule will use the same proportion of tax-free component that was locked in at the commencement of that pension.
To illustrate how the proportioning rule works in respect of pensions in practice, consider the following example (ignoring the transfer balance cap implications).
In January 2017, John is 66 years old, still working and is a member of an SMSF. In his SMSF, John’s superannuation interest consists of a tax-free component of $420,000 and a taxable component of $280,000. His total super balance is $700,000. This means the proportion of his superannuation interest that consists of the tax-free component is 60 per cent and the taxable component is 40 per cent.
John commences an account-based pension with just $250,000 of his total superannuation interest. At the commencement of this pension, the tax-free component is $150,000 (or 60 per cent) and the taxable component is $100,000 (or 40 per cent), since his total super interest before commencing the pension was 60 per cent tax-free component and 40 per cent taxable component.
If the value of the assets supporting the pension were to rise, the percentages representing the tax-free and taxable components do not change. Thus, if John’s pension balance, which started at $250,000, were to rise to $400,000 after three years due to his savvy investment decisions, his tax-free and taxable components would retain the same proportion as at the pension’s commencement and will be as follows: a tax-free component of $240,000 (or 60 per cent) and a taxable component of $160,000 (or 40 per cent).
Of course, if the value of the assets supporting the pension were to fall to say $100,000, then the proportion of the tax-free and taxable components would still remain the same as at commencement (that is, $60,000 tax-free and $40,000 taxable).
Accordingly, the following general rules should be noted:
- Where assets will increase in value, the tax-free component is maximised by commencing a pension sooner rather than later (locking in the tax-free component to grow proportionately).
- Where assets will decrease in value, the tax-free component is maximised by commencing a pension later rather than sooner (allowing the decrease in assets to erode the taxable component).
Proportioning rule with an accumulation interest
To illustrate further the above general rules concerning the proportioning rule, consider the following.
Again, the same facts as above: in January 2017, John is 66 years old, working and is a member of an SMSF. In his SMSF, John’s superannuation interest consists of a tax-free component of $420,000 and a taxable component of $280,000. His total super balance is $700,000. This means the percentages representing the proportion of his superannuation interest comprise a 60 per cent tax-free component and a 40 per cent taxable component.
Let’s focus on his accumulation interest this time. Recall, John commenced his pension with $250,000 of his total superannuation interest; he therefore has $550,000 remaining in his accumulation interest. That $550,000 in accumulation would comprise a tax-free component of $330,000 (or 60 per cent) and the taxable component is $220,000 (or 40 per cent). Like his pension interest, the value of his accumulation interest rises and it increases to $800,000 (previously $550,000) after three years due to his savvy investment decisions. Unlike in his pension interest, his tax-free component remains static and the proportion of his taxable component increases in his accumulation interest. His tax-free and taxable components in respect of his accumulation interest are now as follows: a tax-free component of $330,000 (or 41.25 per cent) and a taxable component of $470,000 (or 58.75 per cent).
As the above example illustrates, there is no change to the tax-free component if investments in the accumulation interest increase in value. Thus, the decision to commence a pension with some or all of a member’s benefits at the right time can make a significant difference to a member’s interest over the course of time.
Conclusion
A sound understanding of the proportioning rule is important as it is forms the basis of many strategies, particularly SMSF succession planning strategies. For example, where there is a significant tax-free component, the pension should generally be commenced as soon as practicable for a member where the fund expects to see some growth in the value of its assets. Further, when a member is contributing or rolling back a pension into accumulation, stay alert to the effect on what will happen to the tax-free and taxable components, since these two components cannot be separated to maximise each client’s position once these amounts are mixed together.
