In this guide
Commuting a pension is the process where a super fund member converts all or part of an existing pension balance into a lump sum entitlement. Depending on the circumstances and the fund’s rules, the commuted amount may be paid to the member, rolled over where allowed or retained in the fund in accumulation phase.
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
- Where the member wants to reduce the amount held in their pension account.
If this is something you are considering, then you need to be aware of the specific process that SMSF trustees need to follow.
How does it work?
The key point is that a commutation is not simply a cash withdrawal. Trustees need to receive and document the member’s request, understand whether the commutation is full or partial, and make sure any minimum pension and reporting obligations are dealt with before the transaction is completed.
To commute a pension, the member makes a written request to the fund trustees to commute all or part of their entitlement to future pension payments, and to specify whether they want the amount paid out, rolled over where allowed, or retained in the fund in accumulation phase. The trustees then document whether the commutation is full or partial and process the request accordingly.
If the lump sum is paid as an in-specie transfer of an asset 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 arises where a lump sum payment by way of an in-specie transfer of an asset occurs. A capital gain arises if the asset’s market value at the time of transfer is greater than its cost base.
Where all or part of a member’s pension balance is transferred to their accumulation account, there is no capital gains tax event merely because of that transfer, unless the fund sells or otherwise disposes of an existing fund asset.
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Find out moreWhat do you need to know?
When a member requests a full commutation from their pension, trustees must ensure the pro-rated minimum annual pension has been paid for the year up to the day the full commutation takes place, unless a specific exception applies, such as a commutation arising because of the member’s death or for certain Division 293 tax payments or a family law payment split.
This ensures the fund earnings on the assets supporting the pension before commutation can be treated as exempt current pension income (ECPI) for tax purposes.
What are the pitfalls?
One of the biggest pitfalls of commuting a pension to a lump sum is the different tax treatment of income earned on the assets.
The earnings on super balances supporting retirement-phase pensions are generally tax free where the pension standards are met, whereas income earned on accumulation balances is generally taxed at 15%, although that is still lower than most individuals’ marginal income tax rates. This is an issue that needs to be considered where the amount commuted from a pension remains within the member’s accumulation account for an extended period of time.
There are also the issues around capital gains tax on assets that are transferred from the SMSF to the member as an in-specie payment, as mentioned earlier.
The timing of a full commutation is also important. It must occur after the pro-rated minimum drawdown for the year has been met if the income earned on the pension assets before commutation is to be treated as ECPI. The ATO’s position is that the account-based pension ends when the decision to fully commute is documented, so the minimum pension payment must be made before that time if ECPI is to be preserved for the pension period.
The ATO illustrates this timing issue with the following example, showing how paying the minimum amount after the full commutation affects the tax treatment of earnings.
Starting a pension again
Where an SMSF member commutes all or part of their pension and retains those amounts within their accumulation account, they can, at a later date, choose to restart a pension.
If they do, they will need to go through many of the same processes they did when they started their original pension, such as calculating the taxable and tax-free portions of the funds supporting the pension.
A fairly common example of when an SMSF member may wish to fully commute their pension occurs when the member makes additional super contributions after the commencement of their pension. These contributions need to be allocated to the member’s accumulation account in their SMSF, they can’t be added to the existing pension.
For ease of administration, the SMSF member may then request to fully commute their existing pension and roll the pension balance back to the accumulation phase, then combine these balances. Once this has been carried out, the member can then request to commence a new, larger pension from their accumulation account using some or all of their member balance.
A partial commutation
Most of what has been mentioned above relates to the full commutation of a member’s pension, where a member ceases their entire pension and ‘rolls’ or transfers the balance back to the accumulation phase.
Another option is to partially commute a pension, whereby some of the existing pension balance is moved back into the accumulation phase, with some also remaining in the retirement phase.
If a pension is partially commuted, the minimum is still required to be paid for the year, so SMSF trustees need to make sure that either:
- The minimum amount is paid before commutation
- Sufficient assets remain to meet the minimum pension payment standards for that year, based on the original value of the income stream at the start of the year.
The bottom line
SMSF pensions can be very flexible and can provide strong retirement income outcomes for fund members when they are used appropriately. But keep in mind that compliance and reporting obligations also need to be addressed when commutations from an existing pension take place.
If you are considering a commutation from an existing pension, make sure you have written documentation in place that sets out what you are doing. Also consider discussing this with your fund administrator, as they may have standard documentation or processes that you can adopt.
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