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Downward-spiralling asset markets are hitting all superannuation fund balances and SMSFs are no different. As a result, many SMSF retirees are readjusting their retirement plans and looking for strategies that may provide a buffer in the current environment.
Thankfully, the government moved quickly to reduce the minimum annual pension drawdown requirement, which will assist many in avoiding selling down assets in a falling market. However, one of the other strategies that SMSF retirees might choose is to stop one or more pensions and move the balance(s) back into accumulation.
How does it work?
This strategy involves stopping regular pension payments and shifting all funds back into an accumulation 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 transferred into 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 it is allowed in the SMSF’s trust deed and other governing rules. If it isn’t, the trust deed may need an amendment 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 for 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.
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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 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.
So, if the fund doesn’t have the cash to pay the required pension, you may need to cash out some of your assets to pay yourself the minimum drawdown. But at least with the minimum pension amounts reduced by the government (as per the below) this should be a smaller amount than usual.
On 22 March 2020 the federal government announced that the minimum pension drawdown rates would be halved for the 2019/20 and 2020/21 financial years. The rates below show the temporary rates for 2019/20 and 2020/21, and the normal rates for preceding years.
|Age of beneficiary||Temporary percentage factor|
(2019/20 and 2020/21)
|Normal percentage factor|
(2013/14 to 2018/19)
|65 to 74||2.5%||5%|
|75 to 79||3%||6%|
|80 to 84||3.5%||7%|
|85 to 89||4.5%||9%|
|90 to 94||5.5%||11%|
|95 or more||7%||14%|
Source: SIS Act
What are the pitfalls?
One of biggest pitfalls would be the tax treatment of the income earned on the assets. The earnings on superannuation balances supporting pensions are tax-free. Any income earned on accumulation balances is taxed at 15%, but that is still lower than most individual’s income tax rates.
There are also the issues for the SMSF 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 the total 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.
Example: Minimum payment prior to full commutation
Andre is a member of the Summa SMSF and is in receipt of an account-based pension.
On 1 November 2011, Andre advises all trustees of the Summa SMSF, in accordance with the governing rules of the fund, that he wishes to fully commute his account-based pension. The balance of his pension at the time is $60,000.
On 15 November, the trustees transfer assets to him to the value of $50,000 in satisfaction of the lump sum commutation. The trustees also proceed to liquidate the remaining $10,000 to fund the required minimum pension amount in cash. On 30 November, Andre is paid the minimum pension amount of $10,000 in cash.
As Andre’s minimum pension payment was not made prior to the full commutation of his pension, the pension is taken not to have existed for that year of income and any benefits received will need to be treated as lump sums. The fund will not be entitled to treat income or capital gains from Andre’s pension as ECPI in the year the commutation takes place.
Starting a pension again
If, at some point in the future, when the world returns to something resembling normality, the SMSF trustee wants to start a pension again they will need to recalculate the taxable and tax-free portions of the funds supporting the pension and 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 pension 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 to 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.
Pensioners still have to live
SMSF trustee pensioners still need funds to live off if they transfer all funds into accumulation phase. They may have the option of going back to work – something quite difficult in the current economic environment, or perhaps they already have savings they can live off.
Many pensioners will often keep three years of pension payments in cash in the fund to reduce volatility and avoid selling assets into falling markets.
Who could this suit?
Wherever your assets are – accumulation or pension phase – they’re going to fall during the current market turmoil, so a commutation strategy could work best for younger retirees who still have time for their assets to recover. It may take many years for markets to bounce back, so the longer a trustee has to recoup equity losses the better.
This pandemic will dramatically change what our global economy looks like and the current market situation is unprecedented in most of our lifetimes. This is just one strategy that SMSF retirees might like to consider depending on their individual circumstances.
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