Q&A: What is asset segregation in pension phase?

Q: I would love to understand a little more about segregating assets on reaching pension phase. i.e. how it works in practice and reasons when such a strategy might be appropriate?

A: To put it simply, segregating assets is the process where the trustees pick an asset or identify an asset and say that this particular asset is being held only for a certain member or for a class of member. Now, the class of members is usually all members in pension phase, etc.

Let me take you through a proper example on this one. Consider AB SMSF. The members are Adam and Bee, and we’ve got a corporate trustee, AB Pty Ltd as the trustee. Adam and Bee, the directors of the corporate trustee and the members of the fund itself.

Now, if we look at the fund a bit more closely in regards to member balances, we’ve got Adam who’s got a pension of $1.7 million. He started that probably a year or so ago and used up his entire transfer balance cap and he’s left behind $200,000 in accumulation, which he’s not allowed to move more than the transfer balance cap in the pension phase. He’s got $1.9 million in total. His wife, Bee, has $800,000 in accumulation. She’s not yet in pension phase. These are the member balances. We then look at the fund itself and we’ll see that the fund has a property which is worth $1.7 million, some share is worth $800,000, and some cash of $200,000. Member balances are the fund’s assets, which is obviously how superannuation works.

Now, we’re talking about segregating assets, identifying particular assets as being held for certain members or class of members. What could happen here is the SMSF trustees could identify that the SMSF-owned property worth $1.7 million is an asset being segregated or being held solely to cover Adam’s pension. We’ve segregated the property, the $1.7 million property as a pension asset of Adam. There are some things or some issues that we need to cover off here.

Number one, all the income or all the rent from the property is treated as being only income for Adam’s member account, his pension account. So all the rent from the property is allocated to Adams pension account. Now, any expenses that relate to the property, so repairs and maintenance, rates and taxes, anything else that might occur, all those expenses must come from Adam’s pension account because it’s been an asset segregated to his account.

The upside is as the asset, as the property is being held solely to pay Adam’s pension, so it’s 100% in pension phase, all the income from that, all the rent, all the income from the property is tax-free. Any capital gains tax that might apply is also exempt because it’s being held 100% in pension phase. It’s been segregated into pension account of Adam.

We also need to keep in mind that we can’t partially segregate an asset. Let’s just say that Adam’s pension balance was $1 million, not $1.7 million. then we can’t say that that property is segregated to Adam’s pension account. You can’t partially segregate the asset. It’s either segregated in whole or it’s not segregated, it’s held for all members. I hope that part makes sense.

I think one of your questions was, How do I achieve this? What are the things that I need to do? Well, as I always say, check your SMSF trust deed for any fund specifics. In particular, that it either doesn’t mention it or it does allow segregation. I much prefer trust deeds to specifically allow something rather than be silent on it. What we then do is we complete a trustee minute, a trustee resolution in writing that sets out that the asset in question, the particular asset in question, the property is being held, it’s being segregated and being held for, in this case, in Adam’s pension account.

Keep in mind that once all members enter pension phase, so in our old case before, if Bee then enters pension phase, once all members are 100% in pension phase, we no longer have accumulation balances, the fund would automatically be deemed to be 100% segregated anyway. It’s just something to be aware of.

Why am I raising these particular issues here? What are some of the other issues to consider? All income, capital gains tax on deemed, segregated pension assets are 100% tax-free. All growth or losses on that segregated asset apply only to the member or members who have been identified as holding the asset. Consider those that have already used 100% of the transfer balance cap, those close to the transfer balance cap limits, or any taxation issues that are approaching. Any of those three scenarios might warrant you to have a discussion with your SMSF admin provider around using segregated assets.

For instance, if we go back to our example where Adam had a $1.7 million pension, we might say, hey, it could be a good idea to segregate that pension. So all the growth stays in that pension phase. There are a number of reasons when you would consider using segregated assets for those types of accounts, I should say. Importantly, once you’ve decided to segregate an asset, once you’ve decided to say, Hey, this pension is being held only for pension members, don’t ever change the status of that if the only reason for the change is to obtain a tax benefit.

If you change an SMSF asset or any other, I’m referring to SMSFs here, but if you change an SMSF asset to be a deemed segregated pension asset just before you sell it, so you get 100% tax-free capital gains, the ATO might look at that and say, “Hey, that’s Part4A tax avoidance. You’re only doing it to get tax-free outcomes”. There would need to be a very good reason other than tax to change the status from being segregated to unsegregated all the other way around. Now, the most common reason for a change in segregation is actually around property. If we look at a rental property where the income it generates no longer meets the required pension payments. If you look at the yield on a rental property, the rental income, call it 3% or 4%, you’re going to get to a point, for instance, in my case before, when Adam turns 80, that his minimum pension goes up to 7%. He might then need to think about, “Hey, I can no longer just keep this asset as being my own personal pension, segregated asset, as it won’t pay my pension payments”.

It was a quite complex question, but hopefully that helps you with that.