When more than one is better

There is no restriction to the number of pensions that can be commenced and supported within an SMSF. Tim Miller, education manager at SuperGuardian, argues the case for employing a multiple-pension strategy.

The approach toward SMSF pensions fundamentally changed on 1 July 2017. The introduction of the transfer balance cap meant we no longer had unlimited opportunities with regards to commencing pensions. However, we still have strategic opportunities that will allow us to reduce personal tax liabilities for both the receiving member and any non-dependent beneficiaries they may have.

ATO Taxation Ruling (TR) 2013/5 – Income tax: when a superannuation income stream commences and ceases, has been under review since super reform took hold in 2017, but still holds the key to how pensions operate in the eye of the regulator.

One concept that should always be top of mind, particularly as contribution rules expand, providing greater opportunities to add money over a longer period, is whether SMSF members should have one or more pensions.

Preservation age

Pension strategies witnessed a significant event on 1 July 2021 because that date heralded the introduction of transfer balance cap indexation for the first time. It was also a key date for people born in or after 1963 as those born prior to 1 July 2021 can now access their superannuation, whereas those born on or after 1 July 2021 have to wait another year with the increase in the preservation age to 59.

Preservation age is obviously the key to commencing a transition-to-retirement income stream (TRIS) and is really our first opportunity to start pension planning.

TRIS in accumulation

A member who has attained preservation age but is under 60 will still, in many instances, benefit from a salary sacrifice and TRIS strategy. As highlighted above, preservation age is creeping ever so closely to age 60, so while there may be only a small tax benefit in the first year or two, there will be a greater benefit once the pension payments are no longer taxable to the individual from age 60. This is the case even though the fund is not entitled to exempt current pension income (ECPI) deductions while the TRIS is in accumulation phase. As will be highlighted below, multiple pension interests can provide future taxation benefits to members and a TRIS is the first opportunity for this to arise. Therefore, it is important to recognise that despite the lack of access to the ECPI deduction, the use of a TRIS can be valuable for many other purposes. As stated above, pension planning should start at preservation age, not retirement age.

Pension commencement

The key to pension commencement, as derived from TR 2013/5, is when the ATO considers a pension has started. The terms and conditions of the pension will determine the commencement date, but it cannot precede the date that the member requests/applies for the pension. Further, to be considered a pension, including a TRIS, the rules must not allow the capital supporting the pension to be added to by way of contribution or rollover after commencement. Therefore, the first thing to be considered by a member wishing to commence a pension is whether or not all the necessary monies have been added to the fund by way of rollover or contribution.

Multiple pensions

What is important about the timing of rollovers and contributions is the concept of pension interests. As we know, a member of an SMSF can have more than one pension interest and once a pension commences, it is always to be treated as a separate superannuation interest. This concept also applies to a TRIS in accumulation, which as identified above can still provide benefits to members.

The use of multiple pension interests is generally determined by the needs of the members, often with reference to estate planning. Tax-free and taxable components calculated at the commencement of a pension apply to all pension payments and superannuation lump sums from that interest, therefore if a member is looking to direct particular benefits to particular beneficiaries, then the use of multiple interests may be an appropriate way to achieve this.

Example

Michael, 66, has a $500,000 accumulation balance that is 100 per cent taxable. He has the ability to contribute up to $330,000 as a non-concessional contribution. As part of his estate planning he wants to split his superannuation benefits between his second wife and his adult child from his first marriage.

Step 1 – Michael commences a pension for $500,000 (100 per cent taxable) that is reversionary.

Step 2 – Michael makes a contribution of $330,000.

Step 3 – Michael starts a second pension for $330,000 (100 per cent tax-free).

Michael makes the first pension reversionary to his wife. The second pension is subject to a binding death benefit nomination to his child in accordance with the trust deed and pension contract. Tax law dictates the reversionary pension will be tax-free to the spouse, whether paid as a pension or lump sum. However, as Michael has commenced the second pension with benefits that are entirely tax-free, all earnings will also be attributable to the tax-free component of the fund, meaning upon his death the entire amount will be paid tax-free to his adult child. Had Michael not made this split and started one pension, then any benefit paid to the adult child would have only been 39.75 pre cent tax-free and a tax liability of 15 per cent plus the Medicare levy would have been payable on the balance.

Pension cessation

The ATO has identified what it perceives to be five common events when a pension ceases: • the capital of the pension is exhausted,

• the pension is fully commuted,

• a fund fails to comply with the pension rules, that is, the trustees fail to pay the minimum entitlement in accordance with Superannuation Industry (Supervision) (SIS) Act and SIS Regulations payment standards, and

• death where no automatic reversion exists.

The SIS payment standards concept isn’t all that common as it relates to the payment of a death benefit income stream to a child. The rule is the pension ceases when the child turns 25 unless they are disabled.

Of these events, commutations are the most strategically driven, albeit, as highlighted in the above example, most strategies will have an estate planning focus, it’s just that you have more control over the timing of commutations.

Why commute a pension?

These days people can stop and start pensions as regularly as they like once attaining preservation age. The reasons can be for any purpose, but are often summarised by the following three events:

• roll back to accumulation – capital preservation,

• commence a new pension – add additional contributions, and

• SMSF wind-up or transfer of benefits to another fund.

The ramification of commuting a pension in the retirement phase is that the fund will lose its exempt pension income deduction and as a result tax will apply on fund income beyond the commutation. The more significant ramification from a tax planning point of view is that a member’s tax-free and taxable proportions will no longer be fixed once a pension ceases, other than on commutation due to death.

If we accept the purpose of the commutation is to revert to accumulation for capital preservation, then the expectation is the tax status will change, so specific planning is not necessary, unless the sale of a significant asset with large gains is looming.

Commute and repurchase

If a member has commenced a pension and makes subsequent contributions to their fund, they can elect to refresh their pension by commuting the existing pension and commencing a new pension, or they can run with multiple pensions, as seen with Michael’s example above. However, the member needs to be aware of the following issues.

Pro rata minimum requirements

If a member elects to commute their pension, they must prorate the minimum payment up to and including the day of the commutation. This means if a member elects to commute their pension on 1 July, there must be a prorated pension paid for one day.

If a member commences a new pension with the additional contribution, then in addition to the pro rata requirement on the pension they have commuted, they have an obligation to pay the prorated minimum pension for the number of days from commencement until 30 June, unless the pension commences on or after 1 June.

Multiple pensions

Similar to the concept of whether multiple pensions should be commenced to isolate concessional contributions from nonconcessional contributions, the pro rata requirements should be considered when determining whether to stop and restart a pension or whether to run multiple pensions. If a member elects to run a new pension while retaining an existing pension, then they will still be required to pay the pension for the full year on the existing pension, however, the pro rata for the new pension is only on the new capital amount, not the combined capital amount. Michael’s example highlights this situation.

Example

For the purposes of this example, no 50 per cent discount is applied to the minimum pension as those rules will only apply in 2021/22. Michael, 66, has a $500,000 account-based pension from which he currently draws down $25,000 annually in December. He makes a $330,000 nonconcessional contribution on 31 December. At the time of the contribution, he requests the trustees commute his existing pension and commence a new pension effective 1 January. On the assumption there have been no earnings in the fund for the year, the new pension commencement value is $805,000.Based on the new pension, the prorated pension for six months is $19,960. If Michael commenced a pension for just the $330,000, the minimum pension would have been $8180. When we combine these two scenarios with the $25,000 already drawn down, we get the following results: Two-pension strategy = $33,180 (keeps the existing pension in place) One pension strategy = $44,960

Michael has drawn over $11,000 more than he could otherwise be required to draw. While that might not be an issue, the point of the example is to highlight there are options.

Commutations and the transfer balance cap

Of course, the other thing that needs to be factored into all of this is the transfer balance cap. Clearly in Michael’s situation there is no transfer balance cap issue. However, if he had commenced a pension closer to $1.6 million prior to 1 July 2021, and then was looking to commence a second pension or consolidate after 1 July 2021, he would need to factor in how much indexation he would be entitled to, but also would need to consider the value of the existing pension and what debit that would produce to his transfer balance account should he adopt the commute and repurchase strategy. The multiple-pension strategy does simplify transfer balance account management.

Summary of pension issues

While there are fewer pension strategies available in today’s environment, running multiple pensions is one that can provide many benefits. As highlighted above, it is clear the effect they can have on estate planning, satisfying minimum pension obligations, but also on reducing personal tax liabilities. As is always the case, an individual’s circumstances should dictate the strategy options.