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One of the benefits of retirement is that you can start to withdraw your superannuation tax-free. That doesn’t mean it’s a rule-free zone.
How are super pensions taxed?
Provided your super pension complies with the annual minimum payment requirements, there is no tax payable on either the income you receive or earnings (including capital gains) on the investments supporting the pension.
However, if you fail to withdraw the required minimum, pension income and assets will lose their tax-free status for the full financial year and all withdrawals will be treated as lump sums. Lump sums generally include taxed and tax-free components.
If you fail to make the minimum payments one year but comply the following year, the tax benefits will be reinstated but you will need to start a new pension. To start a new pension, the fund trustee will need to revalue pension assets at market value and recalculate the minimum pension payment.
The Tax Commissioner may show leniency and allow an income stream to continue if certain conditions are met. If the failure to pay the minimum pension amount was an honest mistake resulting in a small underpayment, or outside the control of the trustee, and a catch-up payment is made within 28 days of becoming aware of the oversight, the income stream may continue without needing to be restarted. If the income stream was in retirement phase, there will be no loss of tax exemptions for the year the oversight occurred. A small underpayment is deemed to be not more than one twelfth of the annual minimum.
If you have an SMSF paying more than one pension, both need to meet the minimum payment requirements. If one pension complies and the other fails to pay the annual minimum amount, only that one will need to apply for leniency or lose its tax exemptions.
Tax and Transition to Retirement pensions
The taxation of Transition to Retirement (TTR) pensions is a little different. Since 1 July 2017, if your TTR pension is not in retirement phase then earnings on assets supporting the pension are taxed at 15%. Income remains tax-free.
Retirement phase (previously called pension phase) refers to the period when a super fund pays a super income stream, and the earnings on those pension assets are tax-free.
If your TTR pension pays out less than the annual minimum then the above exceptions may apply, but there are no exceptions if it pays more than the maximum payment, which is 10% of the fund balance.
Pension strategies to reduce tax
In some cases, there may be tax benefits in the timing and amount of pension income and lump sum withdrawals in pension phase.
This is especially so for SMSFs since the changes to the tax exempt (Exempt Current Pension Income or ECPI) rules, where at least one fund member has an amount in retirement phase that is being drawn as an income stream and an amount in accumulation phase.
The three strategies below are based on the minimum pension drawdown amounts prior to the temporary halving of the rates on 22 March 2020. Before embarking on any of these or any other strategies to reduce tax we recommend you seek independent professional advice.
Graeme Colley, Executive Manager, SMSF Technical and Private Wealth at SuperConcepts says that for someone withdrawing more than the minimum pension amount, there can be a tax benefit in taking additional amounts as a lump sum from their accumulation account early in the financial year. That’s because income from the accumulation account is taxed by up to 15% whereas income from the pension account in retirement phase is tax-free. By reducing the balance in the accumulation fund you effectively increase the tax-exempt proportion of your fund.
Colley gives the example of Liam, 62, who is the only member of his SMSF. He is drawing an account-based pension with a balance of $1.6 million on 1 July 2018 and had an accumulation account of $400,000 at that time. That is, the total balance of his fund is $2 million, the tax-exempt portion is 80% (1.6 million as a percentage of 2.0 million) and the taxable portion is 20% (400,000 as a percentage of 2.0 million).
Liam wants to withdraw $80,000 from super in the 2018/19 financial year to meet his living expenses. The minimum pension he is required to take is $64,000, which means he will need to withdraw an additional $16,000 to meet his expected living costs.
Liam could withdraw the full $80,000 from his pension account or take $16,000 as a lump sum, either before or after the pension. Depending on how he withdraws the amounts the fund will end up with different tax-exempt percentages. If he takes it all as a pension monthly through the year the tax-exempt amount would be 79.588% as he progressively reduces the tax-free portion of the fund’s taxable income from the original 80% at the start of the year.
The best outcome is where he takes the lump sum of $16,000 on 1 July and takes the pension payment the following 30 June, resulting in a tax-exempt portion of 80.643%. By taking the lump sum from his taxable accumulation account as early as possible, he has reduced the taxable proportion of his fund. And by drawing a pension from his pension account as late as possible, he maximises the tax-exempt portion of his fund.
In some cases, Colley says it may make sense to stop a pension, add money to maximise the $1.6 million cap, and restart the pension on the same day.
He gives the example of Haley, 60, who commences an account-based pension with $1.6 million and the income in the fund is all tax free. She wants to withdraw $100,000 each year for the next five years, which is more than her $64,000 minimum pension amount. The best strategy would be to withdraw the $64,000 as a pension and the remaining $36,000 as a lump sum by commuting (stopping) the pension. The commutation would reduce the amount counted against her balance transfer cap and allow her to commence a pension at a later date with the cap space that becomes available. By structuring withdrawals so her total superannuation balance is reduced, she can make non-concessional contributions in the next financial year if she wishes.
Another strategy worth considering is the timing of asset sales to maximise tax exempt income. Where a fund is wholly in pension phase for part of the year when it is 100% tax exempt, and wholly in accumulation phase for another part of the year with 0% tax exemption, it makes sense to sell assets when the tax-exempt portion is the highest.
The good news is that there is no tax payable on either the income you receive from your superannuation pension or earnings (including capital gains) on the investments supporting the pension, provided you comply with the annual minimum payment requirements. These minimum drawdown amounts have been halved temporarily for the 2019/20 and 2020/21 financial years, so you may need to seek independent financial advice on the strategies that will provide the best after-tax outcome for your circumstances.