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There are many circumstances under which an SMSF retiree might consider commuting all or part of their allocated pension. Concerns about falling asset values, the need for an unexpected cash injection for a large purchase or to assist a dependent family member are just a few.
Essentially, commuting a pension just means to stop it and transfer it to a lump sum but there are particular processes SMSF trustees need to follow in order to do this.
How does it work?
This strategy involves stopping regular pension payments and shifting all funds back into an accumulation account within the SMSF. To do this, a member needs to make a request in writing to the fund for their entitlements to future super income stream benefits to be commuted. If the member wishes, the pension balance can be paid out but it can also be kept in the fund and added to the member’s accumulation balance.
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 the pension balance is transferred to the member’s accumulation account, there is no capital gain as it occurs only if the fund sells or disposes of the investment.
If the asset was owned for less than a year and subsequently sold after the transfer to the accumulation account, the full capital gain must be added to the fund’s taxable income for the year. If it has been owned for more than a year, then a one-third discount applies and only two thirds of the taxable capital gain will be taxed in the fund.
What do you need to know?
The important thing to remember about this strategy is that you are still legally required to pay yourself the pro-rated minimum annual pension for the year if you want the earnings on the funds supporting the pension prior to commutation to be considered exempt current pension income (ECPI) for tax purposes.
The ATO also stipulates that a payment resulting from a full commutation cannot count towards the required minimum annual pension amount.
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.
|Age of beneficiary
|65 to 74
|75 to 79
|80 to 84
|85 to 89
|90 to 94
|95 or more
Source: SIS Act
You also need to complete a transfer balance account report and lodge it with the Australian Taxation Office.
What are the pitfalls?
One of biggest pitfalls of commuting a pension to a lump sum would be the different tax treatment of the income earned on the assets. The earnings on super balances supporting pensions are tax free. Any income earned on accumulation balances is taxed at 15%, but that is still lower than most individuals’ income tax rates.
There are also the issues around capital gains tax on assets made in specie as mentioned earlier.
In addition, the timing of the commutation is important. It needs to be made after a pro-rated minimum drawdown for the year if the income earned on the pension prior to commutation is to be considered ECPI.
The ATO uses the following example to illustrate how paying the minimum amount after the commutation impacts the tax treatment of earnings.
Starting a pension again
A trustee can still choose to restart a pension in the future. If they do, they will need to go through many of the same processes they did when they started their original pension (see SuperGuide article How to start a pension), such as calculating the taxable and tax-free portions of the funds supporting the pension. But in this instance, they will need to use the proportionate method to do so.
A partial commutation
Another option is to partially commute a pension, whereby some of the funds are moved into accumulation phase with some remaining in retirement phase.
If a pension is partially commuted, the minimum is still required to be paid for the year. But as long as the pension paid at the time of the partial commutation, plus the pension balance after commutation, is at least the minimum amount in total, the pension will continue to comply with the pension standards.
On this matter the ATO says:
The taxable and tax-free components of any partial commutation payment must have the same proportions as those determined for the components of the separate interest that supported the pension when the pension commenced.
SMSF trustee pensioners will need to consider how they can generate an income to support their lifestyle if they fully commute a pension and receive a lump sum. They may have the option of going back to work, or perhaps they have other sources of income they can live off. But if these kinds of options are not available, a partial commutation may be a better strategy to boost cash in hand, but also maintain a source of income.