Note: We have created this valuable guide to assist those readers running SMSF pensions, or for any reader considering starting a SMSF pension.
In a recent speech to an accountants’ conference, Kasey MacFarlane, ATO’s Assistant Commissioner SMSF Segment, clearly articulated the key SMSF pension rules, and how SMSF trustees can meet those key requirements.
The ATO’s MacFarlane outlined the most important issues to consider when setting up and running a SMSF pension, and also explained what to consider when ceasing a SMSF pension. We have translated this very helpful but fairly technical presentation into a layperson’s guide to SMSF pensions for our SuperGuide readers.
Easy-to-understand information on SMSF pensions is in great demand as the number of SMSF members in pension phase continues to increase. According to the ATO, 39% of SMSF members reported receiving pension payments, and about 8.5% of SMSF members are receiving transition-to-retirement pensions (TRIPs). Currently, just over 204,000 SMSFs (46% of SMSFs lodged) reported some portion of their earnings as tax-exempt (exempt current pension income) and the ATO predicts that a further 250,000 SMSF members will become eligible for a SMSF pension within the next 10 years.
SMSF pensions: ATO’s top 20 tips
Continue reading to discover what the ATO considers to be the key issues for SMSF trustees to be mindful of when starting a pension, when paying a pension, when calculating exempt current pension income, and when ceasing a SMSF pension. We have structured the article into 20 handy tips on how to run a SMSF pension within the super and tax rules.
A. Setting up and starting a SMSF pension
1. Check fund member has reached preservation age
According to the ATO, whether a fund member has reached preservation age is a ‘fundamental but critical question’. Since 1 July 2015, in practical terms, the preservation age has increased from 55 to 56 years: anyone who has not yet turned 55 as at 1 July 2015, will have to wait at least one more year before they can retire, and even longer if born after June 1961. For more information on your preservation age, see SuperGuide article Accessing super: What is my preservation age?
2. Are there any cashing restrictions when starting a SMSF pension?
The ATO warns that SMSF trustees should check whether there are any cashing restrictions associated with the condition of release a fund member is using to start a pension. For example, if a person has reached preservation age but continues to work full-time, then such a member can only start a transition-to-retirement pension (TRIP)(which has more restrictive payment conditions), rather than a standard account-based pension. For more information on conditions of release see SuperGuide article Accessing super early: 14 legal ways to withdraw your super benefits, and for more information on TRIPs, see SuperGuide article TRIPs: 10 important facts about transition-to-retirement pensions
3. Check the SMSF pension type is allowed by the fund’s trust deed
According to the ATO, some older trust deeds are still in existence and those older deeds don’t reflect the many changes to the super rules in recent years. The most relevant instance is where a transition-to-retirement pension is not anticipated in a trust deed because the deed has not been updated to allow for such a pension. The ATO flags that although it doesn’t get involved in resolving disputes between trustees, if a SMSF trustee pays a pension that is contrary to the terms of a trust deed, the ATO may ask whether the pension is a complying pension, and whether the fund assets have been inappropriately released. For more information on updating trust deeds, see SuperGuide article SMSFs for Beginners: Updating SMSF trust deeds.
4. Determine the market value of assets that will support SMSF pension
The super rules require that before a SMSF pension is started that the SMSF trustees need to determine the market value of the fund assets supporting the SMSF pension. According to the ATO, getting this valuation correct is central to the calculation of the annual minimum pension payment. The minimum pension payment (see Tip 6 below) is a key requirement when running a SMSF pension. If the SMSF trustees do not pay the minimum pension amount each year, the SMSF pension may not be eligible for tax-exempt earnings (ECPI), and existing allocation of tax-free component and taxable component. For more information on valuation of SMSF assets, see ATO document Valuation guidelines for SMSFs.
5. Not possible to add capital to existing SMSF pension
You cannot add capital to a super pension once the pension has commenced. You can however start a second pension, or you can cease your existing pension and restart a new pension with original pension assets plus additional capital, such as super contributions made to the fund, or rollovers from other funds. If you want to add super contributions, or rollovers from other super funds, then the original SMSF pension will have to cease and you then start a new pension. If you do cease a pension, you must make a pro-rated minimum pension payment for the part of the financial year the pension was in existence. For more information, see SuperGuide articles:
- SMSF pension: Can I still make super contributions?
- SMSF pension: How do I start one?
- Tax-deductible super contributions: Timing start of pension is essential
B. Paying a SMSF pension
6. Must meet the annual minimum pension payment requirements
You must make annual minimum annual pension payment/s, which is based on a calculation using your pension account balance as at 1 July, and a percentage factor based on your age as at 1 July 2015. If you fail to make at least minimum pension payments, then your tax exemption for earnings on pension assets could be at risk, and the underpayment could be treated as lump sums rather than pension payments (see Tip 9 for an explanation of what happens if you underpay annual pension payments). For more information on minimum pension payments, see SuperGuide articles SMSF pension: How do I calculate my minimum pension payment? and Minimum pension payments for 2018/2019 year (and for 2017/2018 year).
7. Watch liquidity when holding property and paying SMSF pension
According to the ATO, the ability to meet minimum pension payments can be difficult for a SMSF where the sole asset, or main asset, is property. The ATO has observed that SMSFs that invest heavily in property struggle the most with finding the cash to meet minimum pension requirements. A more recent concern for the ATO is that liquidity issues are worsened for SMSFs in pension phase when the asset has been purchased using a limited recourse borrowing arrangement, because earnings within the fund are diverted to pay loan commitments leaving insufficient funds to pay minimum pension amounts. For more information on SMSF borrowing see SuperGuide article SMSF borrowing: Investing in property (what’s OK and NOT OK).
8. Pension payments must be paid in cash, in most cases
The ATO confirms that you cannot pay a pension payment as an asset transfer: you must make the payment as a cash payment. A payment treated as a lump sum that is paid from a pension account can be paid as an asset transfer (in-specie transfer), but this payment is considered a separate lump sum payment rather than meeting your minimum pension payments. If you make a lump sum payment from a SMSF pension account, you still have to meet your minimum pension payment requirements, except in one instance.
According to the ATO, the only instance where a pension payment can be made in-specie (that is, paid in the form of an asset rather than cash), is as a result of a partial commutation of the super pension. In such an instance, the pension does not cease and the in-specie transfer counts towards meeting the minimum pension payment requirements. For more information about the treatment of lump sums paid from pension accounts, see SuperGuide article SMSFs: Taking a lump sum from your super fund (5 Q&As).
Note: The ATO warns that any SMSF having difficulty meeting minimum annual pension payment requirements cannot treat a prior in-specie payment (asset transfer rather than cash asset) as a partial commutation. Such a payment would be treated as a lump sum payment only, rather than partial commutation. According to the ATO, a partial commutation will only be recognised where the fund member has made an election in writing “at the time immediately before the purported partial commutation to have consciously exercised to exchange something less than their full entitlement to receive future pension payments for an entitlement to a lump sum”. The fund’s trust deed and the pension agreement (rules) must also permit a partial commutation.
9. Pension payment must be an actual payment, not just a journal entry
According to the ATO, to meet the pension payment requirements you must actually make a payment, rather than make the payment only on paper. The SMSF pensioner must have received an actual payment and their SMSF pension account balance must be actually reduced by that payment, before the ATO considers that a pension payment has been made.
A journal entry is not enough rather there needs to be a payment. Similarly, the ATO considers that writing a cheque before the end of the financial year, but the cheque then not being presented until the next financial year (when sufficient funds are available) does not demonstrate a pension payment has been made in the earlier financial year.
10. What happens if you underpay the minimum pension payment?
If you underpay your minimum pension payments for a financial year, the potential consequences are that you lose the tax concessions associated with having a pension account, in particular, tax-exempt pension earnings,
In certain circumstances, a catch-up payment in the following financial year can be treated as having been made in the previous financial year. This administrative concession by the ATO is known as the Commissioner exercising his general powers of administration (GPA).
If the circumstances of the payment meet specific ATO criteria, then SMSF trustees can self-assess the GPA. For example, a SMSF trustee can self-assess if the underpayment was an honest mistake and represented no more than 1/12th of the minimum annual pension payment. If the underpayment is greater than 1/12th, the trustee will need to actively apply to the ATO for exercise of the ATO. For more information on the circumstances that will allow a SMSF trustee to self-assess and forgive an underpayment of the minimum pension payment see SuperGuide article SMSF pension payments: A little bit under may be OK.
If the SMSF trustee does not meet the strict criteria for self-assessment, the trustee can then apply directly to the ATO (if the underpayment was due to an honest mistake and only small underpayment although larger than 1/12th of the minimum payment, or trustee is able to demonstrate it was caused by matters outside his or control).
If the GPA is exercised either by trustee self-assessment, or by the ATO exercising the GPA, the SMSF pension is taken to continue (rather than cease), and all pension income for the year will be treated as exempt current pension income. For more information on the implications of underpaying the minimum pension requirements, see SuperGuide article SMSF pension: What happens if I don’t withdraw the annual minimum pension payment?
C. Calculating exempt current pension income (ECPI)
11. Rules when running both a pension account and accumulation account
When running a SMSF pension, the earnings on pension assets are exempt from tax, and are officially known as exempt current pension income (ECPI). The ATO is very strict on the rule that only earnings on pension assets can enjoy this tax exemption so SMSF trustees must clearly identify this income.
If you choose to pay a SMSF pension and not segregate the pension assets (earnings are tax exempt) from assets in accumulation phase (earnings on these assets are taxed), then you have decided to use the ‘unsegregated method’ to calculate the ECPI. Using this method you need to obtain an actuarial certificate, which must be obtained before the SMSF’s tax return is lodged.
If you choose to segregate pension assets from accumulation phase assets, then you don’t need to obtain an actuarial certificate.
Important: The ATO has received a lot of queries about whether an actuarial certificate is required when a SMSF pension starts part-way through an income year, and the segregated method is used. According to the ATO, historically the answer has been yes, an actuarial certificate is required when a SMSF pension starts part-way through the year, even when the SMSF trustees use the segregated method. Interestingly, the industry view for such a situation was that an actuarial certificate was NOT required where a pension was started part-way through the year, and the SMSF pension assets were segregated. In late 2015, the ATO confirmed that a SMSF pension started part-way through a financial year (that is, after 1 July), with segregated pension assets, does not require an actuarial certificate for that year, in order for it to report ECPI in the SMSF tax return.
12. Can assets be partially segregated?
According to the ATO, it is not possible to segregate part of an asset. For example, the ATO considers it is impossible to separate a holding of real property, because you cannot “demonstrate the asset was separate and held solely to support pension liabilities”. In such an instance, a SMSF would need to obtain an actuarial certificate to identify exempt current pension income.
The ATO distinguishes a parcel of shares however, which can be separated into individual shares. The ATO also distinguishes a sub-account of a bank account which can be considered a segregated pension asset (see ATO’s Tax Determination TD 2014/7).
13. Non-arm’s length income (NALI) in pension phase is not exempt from tax
Non-arm’s length income (NALI) is never exempt from tax, regardless of whether it is in accumulation phase or pension phase. Such income is taxed at 47% rather than the usual 15% tax normally associated with super fund earnings. NALI is taxed at 47% in accumulation phase or in pension phase. For more information on NALI, see SuperGuide article SMSF investment: Can I invest my super money in my own company
Note: In 2014, the ATO released two Interpretative Determinations (ATO ID 2014/39 and ATO ID 2014/40) which outlined when non-commercial limited recourse borrowing arrangements involving related parties may be subject to the non-arm’s length income rules. If an LRBA is non-commercial and considered NALI, the ATO warns that NALI would apply to dividends, interest and any capital gains on disposal of the asset acquired through the LRBA. For more information on SMSF borrowing and property see SuperGuide article SMSF borrowing: Investing in property (what’s OK and NOT OK).
14. Dividend stripping arrangements threaten tax-exempt income
According to the ATO, dividend stripping arrangements create tax-free income, and affect a super fund’s ability to report exempt current pension income (ECPI) when the fund is in pension, and the availability of concessional tax treatment when a fund is in accumulation phase.
The ATO has previously described such a strategy as “A retirement planning arrangement we’re seeing also involves a private company with retained earnings distributed by way of a franked distribution to an SMSF in circumstances where the SMSF is entitled to a refund in relation to franking credits attached to the distribution.”
The ATO is examining several arrangements “involving individuals, companies and SMSFs that [the ATO] believe may have entered into dividend stripping arrangements and artificially created a series of inter-related transactions designed to generate significant tax benefits.”
For more information on the ATO compliance hit list, and the potential penalties for breaking the super laws, see SuperGuide articles SMSF compliance: ATO’s hit list for the 2018/2019 year and SMSF trustees face big penalties: 2018/2019 guide
15. Most fund expenses cannot be claimed in pension phase
The ATO has observed that a number of SMSFs incorrectly claim expenses as a deduction even though some fund members in pension phase. According to the ATO, in most cases, a SMSF cannot claim a deduction for expenses incurred in gaining or producing exempt income, unless a specific deduction provision applies.
The ATO provides the following guidance: “Where an expense is deductible under the general deduction provisions and the fund has both accumulation and pension members, the expense needs to be apportioned. This is because only the portion of the expense that can be linked to assessable income is deductible.”
Note: Some deductions can be claimed in full whether the SMSF is in pension phase or accumulation phase. According to the ATO, these deductions include tax-related expenses (cost of preparing and lodging SMSF return and presumably tax advice), the cost of obtaining an actuarial certificate and the ATO superannuation supervisory levy. For more information on what the ATO considers are allowable deductions in pension phase see this ATO link.
16. Be careful when calculating tax losses
Carry-forward losses can be problematic for SMSFs in pension phase because fund earnings are tax-exempt. According to the ATO, in many cases, a tax loss of a pension-phase fund can’t be applied against its assessable income in a future year.
The ATO provides the following guidance: “If the fund’s taxable income is a net tax loss and it has ECPI, it must reduce its tax losses by its net ECPI before it can carry forward those losses to later income years. If a SMSF has a carry-forward loss from a previous income year, and it has ECPI, the carry-forward loss must be reduced by its net ECPI before it can be deducted from its assessable income.”
For treatment of capital losses see this ATO link.
D. Ceasing a SMSF pension
17. When does a SMSF pension cease?
The ATO refers SMSF trustees to Taxation Ruling TR 2013/5 which explains the most common circumstances for a pension ceasing, namely:
- When there is no longer a member entitled to be paid a super pension, or when there is longer a dependant beneficiary of a member who is automatically entitled to be paid a super pension
- Failure to comply with pension rules
- Pension is required to be cashed according to pension rules, for example, financially dependent child of deceased member reaches the age of 25 (and the child does not have a disability)
- Capital supporting the pension has been reduced to nil
- Pension is fully commuted and lump sum is payable (but doesn’t cease when partially commuted)
- Death of a member receiving SMSF pension (see Tips 18, 19 and 20 below)
For more information on when SMSF pensions cease see TR 2013/5
18. Death benefit payable as automatic reversionary beneficiary – pension continues
According to the ATO, where a SMSF is paying a pension and the pensioner dies, if there is an automatic reversionary beneficiary in place, the existing SMSF pension continues because it automatically transfers to the nominated beneficiary. The nominated beneficiary continues to receive the pension on the same terms, and the tax-exemption on pension income continues.
The ATO however flags some area of concerns with reversionary pensions, including:
- Eligible to receive pension. Be certain that the nominated beneficiary is entitled to receive a death benefit pension. Only certain dependants can receive a death benefit pension, specifically, a spouse (same-sec or de facto), a child under the age of 18, a child who is disabled (can receive pension indefinitely), and a financially dependent child under the age of 25 (although interest must cease before they turn 25)
- Must pay minimum pension payment. Annual minimum pension payment must be paid for the financial year when the deceased pensioner dies, based on the deceased pensioners minimum payment calculation. In the following financial year, the minimum pension payment will be based on the reversionary beneficiary’s age.
- Transition-to-retirement pension becomes an ordinary account-based pension. If a transition-to-retirement pension (TRIP) member dies and the pension automatically reverts to a beneficiary, the TRIP becomes a standard pension with no upper limit on payments, and no limits on lump sums.
19. Death benefit with no automatic reversionary beneficiary – pension ceases
According to the ATO, where the deceased member’s benefit was not established with an automatic reversionary beneficiary, then the pension ceases at the time of death of the fund member. There is no requirement to pay any remaining amounts of the minimum pension payment requirement in the year of death, which means the tax exemption will remain up to when the pension ceased, even if pro-rated minimum pension payments have not been made.
If the death benefits are then used to start a new pension by the death benefit beneficiary, then new tax-free and taxable components will be calculated, and a new minimum pension amount is calculated and required to be paid during the financial year (for more information, see Tip 6 earlier).
Note: The exempt current pension income (ECPI) can continue to be claimed after the fund member’s death until a super benefit is paid, and this tax exemption continues whether the death benefit is paid as a lump sum or death benefit pension. The exemption continues provided the payment of death benefits is done ‘as soon as practicable’. According to the ATO, soon as practicable means “normally would not exceed six months from the date of death. If a longer period is required, the trustees should be prepared to demonstrate why it was not practicable to pay the death benefit sooner. For more information on the payment of death benefits and the tax exemption on earnings see SuperGuide article SMSF pension earnings remain tax-free after death.
20. Tax treatment of death benefit lump sums
The ATO warns that many SMSF trustees misunderstand a dependant for super purposes (can receive super death benefits) with a dependant for tax purposes (can receive those super death benefits tax-free). For example, a financially independent adult child of a deceased fund member can be a dependant for super purposes, but a non-dependant for tax purposes. The ATO reminds trustees that they must correctly identify the tax-free and taxable components of a death benefit (tax is payable on the taxable component for non-dependants for tax purposes). For more information, see SuperGuide articles Superannuation death benefits: Dear Dad, Tax for everything and Superannuation death benefits: Beware the dastardly death tax, and retirement cap