The pension toolkit

Practitioners need to consider many elements when providing advice related to pension strategies. Tim Miller details the options available and their implications with regard to income streams.

In issue 35 of this magazine, in an article titled “When more than one is better”, I identified multiple pensions could be commenced to isolate contributions or benefit components for estate planning purposes and that pro-rata requirements should be considered when determining the use of such strategies.

This is just one of a number of strategies advisers need in their pension toolkits when discussing how best to handle pensions in a post-super reform environment. With the onset of non-work-related contributions up to age 75 coming into effect from 1 July, now is a great opportunity to look at other key considerations for your pension clients.

Partial commutations versus withdrawals

Lump sum benefits, in the form of a partial commutation, do not count towards the minimum pension requirement and can be an in-specie payment, unlike pension payments, which must be in cash.

If a member wants to take a benefit that exceeds their minimum pension requirement, there may be circumstances where it might be more appropriate to treat the benefit as a lump sum rather than a pension. If an amount is not to be treated as a pension payment, the member must notify the fund trustees of their intention to take the benefit as a superannuation lump sum so this can be reported against their transfer balance account (TBA) within the appropriate timeframe. As partial commutations are a debit to the TBA, they provide future transfer balance cap (TBC) space for the member.

Therefore, consideration should be given to how withdrawals are treated each year, especially in light of the government’s recent decision to extend the 50 per cent minimum pension drawdown discount for 2022/23.

For an SMSF the allocation of payments as a lump sum or a pension and whether to take it from a pension interest or an accumulation interest can impact the tax paid by the fund.

Withdrawal options

There are alternatives for how any amount above the minimum pension can be accounted for by SMSF trustees, subject to whether the member has an additional accumulation interest or not.

Lump sum withdrawal from accumulation account

If available, the excess amount may be withdrawn from an accumulation interest. Withdrawing from an accumulation interest does not reduce the personal TBC as this relates only to amounts held in a retirement-phase pension interest. However, it does reduce the amount of taxable component of the fund, meaning more of the income, including capital gains, will ultimately be exempt from tax.

Drawing down from the accumulation portion of the fund will generally increase the exempt income percentage for the year as determined by an actuary. The higher the percentage, the lower the income tax for the SMSF.

Lump sum withdrawal from pension account

While the above option is only available where accumulation interests exist, members may also choose to withdraw the excess over their minimum pension requirement as a partial commutation lump sum from their retirement-phase pension account(s) to free up some of their personal TBC space.

Additional space within this cap can enable future contributions or rollovers from other funds to be included in the tax-exempt pension environment. This can be handy in light of the contribution changes and the possibility of downsizer contributions at a later stage in life.

A commutation creating a debit to the TBA can therefore be of future benefit to the SMSF.

It is not a requirement to take the minimum before taking a lump sum, as long as the minimum is taken over the course of the year.

Treating excess payments as pension drawdowns

Leaving any amount above the minimum as a pension payment, where an accumulation account exists, means the proportion of the fund in retirement phase is likely to be reducing relative to the accumulation-phase balance, unless contributions are still being made. This will have a flow-on effect to the actuary percentage and tax calculation.

Additionally, treating any withdrawal above the minimum as a pension payment rather than a commutation from a retirementphase pension means you don’t have the opportunity to create room in the TBA that may be of use in the future. This may not be an issue for low member balances.

Death of a pensioner

It is conceivable that where benefits are drawn from is likely to have an impact on those beneficiaries the member intends to leave their superannuation interests to upon their death, more so than on the member themselves.

Withdrawing monies from an interest with a high taxed component versus those with higher tax-free components can be beneficial if interests are to be distributed to non-tax dependants, such as adult children.

However, as a significant proportion of death benefits is traditionally paid to a spouse, the bigger issue may be appreciating the difference between autoreversionary pensions and the use of trustee discretion regarding death benefits that provides for a new death benefit income stream to commence, as each has different reporting, payment and strategic outcomes.

Existing pension versus new pension

A great deal of focus is given to the issue of paying pensions to a surviving spouse and the concept of automatically reverting it to them versus trustees having discretion as to how the death benefit is paid, which would result in the original pension(s) ceasing and a new one(s) commencing.

Traditionally the issue revolved around the tax exemption afforded to funds paying a pension and the consequence of the pension ceasing. This was addressed with the provision that the exempt pension income deduction exists following the death of the pension up until the time the death benefit is paid so long as the death benefit is paid as soon as practicable.

The issues created since the introduction of the TBC are those of timing, reporting and valuations, as well as convenience.

TBA reporting

Reversionary pensions are afforded a 12-month TBA amnesty, for want of a better term, whereby the reversionary beneficiary has 12 months from the date of death until the pension will appear as a credit in their TBA. This provides a fund ample time to adjust existing pensions so as not to create an excess where the combined value of the deceased’s benefit and the surviving spouse’s exceeds their personal TBC. The choices available within that 12-month period would be for the surviving spouse to commute their own pension back to accumulation, providing an opportunity to retain the money in the super system, or commute part of the reversionary pension, which would require the money to be taken out of the fund as a lump sum, or both.

Reversionary pensions provide valuation certainty for the amount credited at that time. It is the value at the date of death.

A significant benefit of this 12-month amnesty is that effectively the fund is generating exempt income on both the deceased’s and surviving spouse’s pensions.

Death benefit income streams, where the trustee uses their discretion to commence a new pension following the death of the member, must be reported based on the value on the date it is commenced, which is subject to when the trustee determines to commence it. While this approach still gives the trustees and surviving spouse time to consider what actions are necessary in the event the new pension would create an excess TBA position, any decision must be made as soon as practicable and there is no way of having certainty on the value of the new pension at a future date.

The question therefore is whether trustee discretion in an SMSF is a good thing.

Minimum pension obligation

One relevant matter when discussing reversionary versus discretionary pensions is the minimum pension obligation.

If a pension automatically reverts to the spouse on the death of the member, then the fund has an obligation to pay the pension for the entire year as calculated at the previous 1 July.

If, for example, the intention was to pay the pension on an annual basis and the member dies towards the end of the financial year, then the fund could be faced with the possibility of failing to meet the pension standards if the pension isn’t paid to the reversionary spouse due to trustee oversight. This would result in the fund losing its exempt income status.

The ATO has gone to some extent to address this by providing relief that stipulates while the pension is deemed to have stopped at the start of the year for exempt pension income purposes, the fund won’t be in breach of the payment standards if the pension is paid correctly the following year.

If a pension is discretionary, the pension calculation provides a completely different outcome. Usually when a pension ceases there is an obligation to pay a pro-rata pension. This obligation does not apply when the reason for the commutation is death. So in the event of a member dying during a financial year having not paid any pension, it does not impact the fund, that is, the exemption is still available.

If then the trustee is determined to pay the pension to the spouse, that income stream would be calculated based on the spouse’s age and would be subject to the pro-rata rules. A new pension commenced on or after 1 June would not require a minimum to be paid. In the event the member dies late in the year, as above, it may not be practical for the pension to be commenced in the current year, but the fund would still receive the income exemption despite no pension being paid at all. Quite a different outcome.

TSB and contributions

Another consideration for reversionary versus discretionary pensions is a member’s total superannuation balance (TSB) and their capacity to make contributions to a fund.

From 1 July, more individuals will be able to make non-concessional contributions to super given the removal of the work test for individuals up to the age of 75, however, their capacity will be limited by their TSB at the preceding 30 June.

This is where the reversionary pension 12-month amnesty may be problematic.

While nothing shows on the TBA, the entitlement has transferred and as such the value of the reversionary pension will count towards the TSB.

If the combined value of the member interest and the deceased’s interest exceeds the general TBC, currently $1.7 million, then the surviving member is unable to contribute. However, if the trustee has not yet determined to commence to pay the benefit, the member will not yet be in receipt of the deceased’s proceeds and their balance will be lower. This could bring into play the use of recontributions, which could provide better tax outcomes for any non-dependent beneficiaries.

When contemplating pension strategies there are numerous matters to be taken into consideration. Is the client better off with one pension or multiple pensions? Reversionary pensions offer peace of mind, but may not necessarily be the answer to everyone’s situation. How will clients deal with excess lump sum withdrawals?

There are many strategies available for account-based pensions; the key is determining what is right for your client.