Commuting an SMSF account-based pension

Commuting a pension simply refers to the process where a super fund member converts all, or part, of their existing pension benefit into a lump sum payment.

There are a number of circumstances where an SMSF member might consider commuting all or part of their existing pension, including:

• An unexpected need for cash for a large purchase or to help a family member
• A desire to combine multiple pension accounts
• The transfer of additional funds from an accumulation account into a single pension account
• The receipt of a reversionary pension from their deceased partner, which would result in the member exceeding their transfer balance cap.

If this is something you are considering, then you need to be aware of the specific process that SMSF trustees follow.

How does it work?

This strategy involves shifting all, or part, of an existing pension balance back into the member’s accumulation account within the SMSF.

Once this has been carried out, the member can then access a lump sum from their accumulation account or simply leave the amount in the accumulation phase.

To do this, a member needs to make a request in writing to the fund trustees for their existing entitlements to future pension payments to be commuted. Essentially ‘rolling’ back part or all of the pension balance to the accumulation account. The member would then, where relevant, request in writing for a lump sum to be paid out from the fund.

If the lump sum is made by an in-specie transfer of assets to the member, it is important that this is allowed in the SMSF’s trust deed and other governing rules. If it isn’t, the trust deed may need amending to allow the in-specie transfer.

There may also be capital gains tax implications for the SMSF if a capital gain is made on an in-specie transfer of the investment to the member. There will be a capital gain if the value of the asset at the time of transfer to the member is greater than the value at which it was acquired.

Where all or part of a member’s pension balance is transferred to their accumulation account, there is no capital gains event unless the fund sells or disposes of an existing fund asset.

What do you need to know?

When a member requests a commutation from their pension, it is important to remember that the trustees are still required to pay the pro-rated minimum annual pension for the year. This is to make sure that the fund earnings on the assets supporting the pension prior to commutation are considered to be exempt current pension income (ECPI) for tax purposes.

For example, if an SMSF member fully commutes their pension on 1 March, before doing so, the SMSF trustees would be required to pay at least the pro-rata amount for that pension for the number of days in the financial year that the pension was in place.

The pro-rata minimum payment amount that must be paid prior to commutation is calculated using the formula:

Pro-rata minimum payment amount = minimum annual payment amount × days from the commencement day to the day pension commuted ÷ 365 (or 366 in a leap year)

The minimum percentage factors are shown in the table below.

Source: SIS Act

It is also important to note that where a full commutation of a pension occurs, the fund trustee will need to complete a transfer balance account report and lodge it with the ATO, noting the cessation of the member’s pension.

What are the pitfalls?