Commuting an SMSF allocated pension

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.

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.

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.

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.

The bottom line

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.