The rewards of recontributions

Withdrawal and recontribution strategies can result in achieving better tax outcomes for SMSF members and their death beneficiaries. Colonial First State head of technical services Craig Day illustrates how this can be achieved in more than one way.

The recontribution strategy is a common strategy used by financial advisers for many years to reduce the tax on lump sum death benefits paid to non-tax dependants. However, there are a range of SMSF specific issues that need to be thought through before implementing any recontribution strategy, including whether it even makes sense to do so.

What is the recontribution strategy?

The recontribution strategy in its most basic form involves a member withdrawing a tax-free lump sum from superannuation and then recontributing back into super. The traditional aim of this strategy is to convert a taxable component into a tax-free component by cashing out lump sums that consist either partly or fully of a taxable component and then recontributing that amount as a non-concessional contribution (NCC), which then counts towards the tax-free component.

For example, a member over the age of 60 with a benefit made up entirely of taxable component could potentially save up to $17,000 in death benefit tax per $100,000 of lump sum death benefit paid to a non-tax dependant by implementing the strategy.

Recontribution quirks for SMSFs

While a simple one-off recontribution works fine in an SMSF, things can get a little more complicated where the amount the client wishes to cash out and recontribute exceeds their NCC cap under the bring-forward rule, as this may require the client to recontribute several times over a number of years. In this case, without a proper understanding of the rules and a little bit of strategy, an SMSF client may not get the outcome they were totally expecting.

For example, while most people implement the recontribution strategy after 60 to ensure the lump sum will be tax-free, it’s important to remember the proportioning rules still apply to require the lump sum to be broken up into its constituent tax components. As stipulated in section 307-125 of the Income Tax Assessment Act 1997 (ITAA), this is done by applying the same tax component proportions to the lump sum as the super interest they are drawn from. For example, a $10,000 lump sum withdrawn from an interest made up of a 30 per cent tax-free and 70 per cent taxable component would consist of $3000 tax-free and $7000 taxable components.

This means with each subsequent recontribution, the following withdrawal will be made up of increasing amounts of tax-free component, thus increasing the number of transactions and time it would take to fully convert a taxable component to a tax-free component via this strategy.

Case study

Andrew, a retired divorcee, turns 65 on 8 August 2022 and has $550,000 in an SMSF that is 100 per cent taxable. He has nominated his non-financially dependent adult daughter, Sabrina, to receive his death benefit via a binding death benefit nomination. If Andrew were to pass away, his death benefit would be subject to tax of up to $93,500 (that is, $550,000 x 17%).

If Andrew implemented a recontribution strategy under the current rules, he could make three withdrawals across a period of three financial years, recontributing the funds back into superannuation each time as NCCs. This would be comprised of a $110,000 contribution in 2022/23 and 2023/24, and then a $330,000 contribution triggering the bring-forward provision in 2024/25 when he reaches age 67.

However, if Andrew recontributed back into his SMSF, a significant portion of his superannuation balance would remain as a taxable component when he turned 67 due to each withdrawal being made up of increasing amounts of tax-free component due to the proportioning rules. For example, after implementing this strategy, he would still be left with a $140,800 taxable component after three years as reflected in the table 1.

TABLE 1 Total Balance($) Tax Free ($) Taxable ($) Taxable (%)

Pre-1st recontribution 550,000 0 550,000 100

Post-1st recontribution 550,000 110,000 440,000 80

Pre-2nd recontribution 550,000 198,000 352,000 64

Post-2nd recontribution 550,000 409,200 140,800 26

In this case, it should be noted Andrew would still get the same outcome even if his NCCs were contributed or credited to a separate accumulation account, that is, the lump sums were drawn from his original account, account A, and the NCCs credited to a separate account, account B.

This is because under regulation 307- 200-02(a) of the Income Tax Assessment Regulations (ITAR) (1997 Act) 2021 the proportioning rules treat all of a member’s different accumulation interests in an SMSF as one superannuation interest. Therefore, Andrew’s two separate accumulation accounts would need to be combined into one to determine the tax components of any subsequent benefit payments.

However, to try and recontribute his full balance before the work test would apply at age 67 (applicable at the time of writing), Andrew could consider recontributing the withdrawn amounts to a different fund, which would ensure all the withdrawals from his SMSF would remain 100 per cent taxable component. Table 2 shows the outcome where his benefits in Fund A are recontributed as NCCs to a second fund, Fund B.

TABLE 2 Total Balance($) Tax Free ($) Taxable ($) Taxable (%)

Pre-1st recontribution 550,000 0 550,000 100

Post-1st recontribution 550,000 110,000 440,000 80

Pre-2nd recontribution 550,000 220,000 330,000 60

Post-2nd recontribution 550,000 550,000 Nil Nil

However, this would require Andrew to have two separate funds, which would potentially increase cost and complexity.

Please note both case study scenarios assume no indexation of contributions caps and that no earnings have accrued and no further concessional contributions have been made over the three-year period. Also, any increase in taxable component due to concessional contributions and/or accrued earnings within accumulation phase would result in Option 1 being even less effective when compared to Option 2.

However, another option could be for Andrew to commence an account-based pension (ABP) within his SMSF prior to commencing a recontribution strategy. Under regulations 307-200-02(b) and 307-200-05 of the ITAR (1997 Act) 2021, this provides a different outcome as the proportioning rules treat an interest that supports a superannuation income stream as a separate super interest. Therefore, if Andrew commenced his ABP with a 100 per cent taxable component, any future lump sum commutations would consist of a 100 per cent taxable component, regardless of whether he had since recontributed NCCs back into an accumulation account in his SMSF.

An added benefit of the above strategy is it could allow a member to segregate taxable and tax-free components into two separate pensions, which could then allow a member to direct death benefits be paid in the most tax-efficient way.

For example, if Andrew wanted Sabrina to receive 20 per cent of his death benefit with the balance being paid to a second spouse, he could achieve this outcome by commencing an ABP worth $550,000 (100 per cent taxable component) and then withdrawing and recontributing $110,000, which he could then use to commence a second ABP for $110,000 (100 per cent taxfree component). This could then be paid to Sabrina tax-free on his death.

Other SMSF recontribution issues

Where an SMSF has insufficient cash to implement a recontribution strategy, the trustees would either need to dispose of assets to provide the required liquidity or the fund could process the recontribution via an in-specie benefit payment and contribution.

However, any strategy involving inspecie transfers would need to be handled carefully as it would require the ownership of the asset to be transferred at the market rate twice in quick succession and the asset would need to be of a class that is able to be acquired from a related party.

In addition, the sale or transfer of any capital gains tax (CGT) assets would trigger transaction costs and a potential CGT liability, which would need to be factored into any cost-benefit analysis of the strategy. Alternatively, where a member had previously commenced a retirementphase income stream, any capital gains would either be fully or partially exempt, depending on the fund’s circumstances.

Trustees should also be very wary of methods that may be promoted as a way of avoiding the potential CGT implications associated with recontribution strategies and SMSFs. These have included:

• recording the cash out and recontribution via journal entry only with no amounts ever leaving or being recontributed back to the fund, and

• a promissory note being passed back and forth between the trustee and member with a benefit payment and contribution being recorded, despite the promissory note never being presented or honoured.

Neither of these strategies have withstood scrutiny, with the ATO issuing both Interpretative Decision 2015/23 confirming benefit payments cannot be paid via journal entry and Taxpayer Alert 2009/10 warning trustees about the potential tax avoidance issues associated with the non-commercial use of promissory notes and cheques.

Is it actually worthwhile doing?

While the recontribution strategy is relatively common, a valid question is whether it’s actually worthwhile doing – especially considering members aged 60 or over can withdraw their benefits tax-free prior to death. In this case, it’s also relevant to note a recontribution strategy:

• only financially benefits the member’s non-tax dependant beneficiaries and could actually disadvantage a client where the fund will incur taxes, such as CGT, and other transaction and administration costs, to implement the strategy, and

• relies on a member’s death benefit actually being paid to a non-tax dependant, such as an adult child, instead of their spouse.

However, withdrawing super prior to death obviously requires a person to know when they are likely to die, which will not be the case in the event of sudden death due to accident or illness. Also, an elderly or terminally ill person would need to have the capacity to withdraw their benefits while still alive. In this case, a person’s enduring power of attorney may also be reluctant to withdraw their benefits prior to death to avoid death benefits tax as they are generally required to act in the best interests of the person and not their beneficiaries.

Other reasons to implement recontribution strategies

A recontribution strategy can also provide a number of other advantages, especially where it involves a spouse. For example, it could allow a couple to equalise their superannuation balances, which could provide a number of benefits. These include:

• maximising the total amount of benefits a couple could transfer to the tax-free retirement phase where one member of the couple has accumulated more than the transfer balance cap (TBC). For example, this could allow a member who had accumulated $200,000 more than the TBC to withdraw the excess amount and recontribute to the super account of their spouse, who could then use it to commence their own ABP (assuming they had sufficient cap space), and

• allowing a client to qualify for any concessions based on their total superannuation balance (TSB), such as the catch-up concessional contribution rules or work test exemption rules, which have TSB eligibility thresholds of $500,000 and $300,000 respectively.

Using a recontribution strategy to increase the super balance of a younger spouse may also allow an older spouse to gain access to a higher rate of age pension, as super in accumulation phase is exempt from the assets and income tests until a person qualifies for the age pension. An individual currently needs to be 66.5 years old to be eligible for the age pension and this threshold is increasing to 67 for those born on or after 1 January 1957.

Anti-avoidance

As the recontribution strategy may result in less tax being paid by a non-tax dependant beneficiary, the application of Part IVA anti-avoidance rules of the ITAA 1936 has always been a possibility.

However, it is important to remember that the application of Part IVA to any recontribution arrangement will always be assessed on a case-by-case basis. So while a plain vanilla recontribution may be fine, if you push the boundaries there are no guarantees.