Multidimensional benefits

A multiple pension strategy has to date been implemented for SMSF estate planning purposes. However, Tim Miler demonstrates how the approach has taken on a new dimension given some recent regulatory developments.

Three things happened in the last week of June and the first week of July. Firstly, the ATO released its updated version of Taxation Ruling (TR) 2013/5 “Taxation Ruling Income Tax: when a superannuation income stream commences and ceases” and a few days later, on 1 July, the stage three tax cuts took effect and the preservation age shifted to age 60. These three isolated events give us food for thought with regards to numerous strategies available via an SMSF, namely running multiple pensions, commencing transition-to-retirement income streams (TRIS) and using salary sacrifice arrangements.

TR 2013/5

Of most significance from the ATO’s ruling is failing to satisfy the pension standards will now likely result in additional member and trustee activity in the year following that in which a fund failed to pay the minimum pension. While the need to consciously commute a pension that has failed to pay the minimum is likely the end result for a fund in this position, there are strategies that can minimise the damage done in the event an SMSF has paid part but not all of its required drawdown.

Multiple pensions for the one member have long been considered valuable for estate planning purposes, but now, more than ever, they can be of value by ensuring not all strategic work already undertaken will be undone by having a pension shortfall.

Multiple pensions

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 until such time the pension ceases, and even then some of the cessation circumstances, such as death, still provide for the benefit to be paid in the original commencement components post cessation. 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 goal.

Example

Dave, 65, has a $500,000 accumulation balance that is 80 per cent taxable and 20 per cent tax-free. He has the ability to contribute up to $660,000 as non-concessional and downsizer contributions following the sale of his primary place of residence. 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. As such, he takes the following action:

• Step 1 – Dave commences a pension for $500,000 (100 per cent taxable).

• Step 2 – Dave makes a contribution of $660,000.

• Step 3 – Dave starts a second pension for $660,000 (100 per cent tax-free).

Dave makes the first pension reversionary to his wife and the second pension subject to a binding death benefit nomination to his child in accordance with the fund’s trust deed and pension contract.

One versus two

If Dave had commenced one pension for $1.16 million, it would have been considered approximately 35 per cent taxable and 65 per cent tax-free, which would have tax ramifications for his adult child.

It would also mean any failure to pay the minimum required would result in a loss of exempt current pension income (ECPI) on the entire amount and a further tarnishing of the tax-free and taxable components.

Let’s consider the following scenario. Dave’s minimum pension obligation is $58,000 and he sets up a quarterly payment of $14,500. However, due to the timing associated with the commencement, his first pension payment occurs in the December quarter of the relevant year rather than the September quarter. He never makes up the first quarter payment prior to 30 June. In total, he has drawn down $43,500. In a single-pension environment, he has no positive outcome, the fund will lose the ECPI deduction and he will need to make a decision to consciously commute the pension after 1 July, which will lead to transfer balance account anomalies and potentially an uptick in the taxable component.

In the situation above, where he sets up two pensions, then the minimums are $25,000 for pension one (reversionary to his wife) and $33,000 for the second. So long as Dave has not stipulated a specific amount to be allocated to a specific pension, he could allocate sufficient drawings to pension two and maintain the ECPI deduction and 100 per cent tax-free status. Granted he would fail the payment standard for pension one, but this would be less severe.

Transition to retirement

A TRIS, if being paid from an SMSF, are a vital part of the membership cycle and a key tool in the estate planning process as they allow individuals the opportunity to create separate interests prior to retiring. Now that preservation age has hit 60, they can also provide varying levels of tax savings as a result of the stage three tax cuts that took effect from 1 July 2024.

With preservation age now at 60, it means any income stream commenced from an SMSF will pay non-assessable non-exempt income. That is a double win for those who have satisfied a nil-cashing restriction condition of release as they will not only receive tax-free income, but the fund will also generate it as a result of the ECPI deduction. So while a TRIS is not entitled to the ECPI, they still retain benefits associated with multiple interests as discussed above.

Salary sacrifice tax deferral

A member who has attained preservation age, but has not retired will still in many instances benefit from a salary sacrifice and transition-to-retirement strategy. Given there are a substantial number of SMSF members at preservation age who also have a total superannuation balance of less than $500,000, the ability to use a salary sacrifice and catchup concessional contribution strategy is significant.

Recognising salary sacrifice arrangements no longer reduce an employer’s superannuation guarantee (SG) obligation, the ability to salary sacrifice and use any unused concessional contributions caps from the previous five years could prove significant even though there is no ECPI deduction for a TRIS in accumulation phase.

So while the loss of ECPI within the super environment does reduce the overall tax benefit, the stage three tax cuts mean for many there is still a tax benefit to be had.

Example

Simone, 60, earns $100,000. Let’s assume Simone’s employer already pays SG on her pre-salary sacrifice income, so she currently has contributions made totalling $11,500 and without salary sacrifice, Simone will pay $20,788 tax, excluding Medicare, and have take-home pay of $79,212. For the past five years she has not made any additional contributions above the SG amount so is entitled to carry forward her unused concessional contributions cap amounts, assuming her total super balance is below $500,000.

If we also assume Simone has at least $420,000 in her SMSF, it means she can commence a TRIS and draw between $16,800 and $42,000 as an income stream. Under the new stage three tax cuts, the low rate of 16 per cent is payable up to $45,000. Let’s look at the outcome if Simone contributes $55,000 via a salary sacrifice arrangement and elects to draw the maximum of $42,000 from her TRIS (Table 1).

She is not only paying less tax overall, but she is receiving more income than on the original $100,000. Even if you factor in the earnings the fund has to pay tax on, they are negligible when compared to the $8250 less tax paid.

The net position sees Simone’s income grow as well as her super balance. This assumes a 100 per cent taxable component.

Estate planning

While there are overall tax savings to be made by using a TRIS, the greatest benefit they can deliver may still be estate planning flexibility as they allow a member to create multiple interests prior to retirement as indicated above.

A TRIS can provide some strategic advantages to members who have attained preservation age as existing benefits can be isolated from future contributions, meaning estate planning strategies that previously relied on multiple income streams can still be commenced during the transition-to-retirement stage of an individual’s life.

The TRIS recontribution strategy

One of the most effective ways to achieve a desirable tax outcome is through a recontribution strategy. This strategy works best once a member commences one or more income streams because if they do not, the member is just recontributing to an accumulation interest, which will have some tax effect, but the contribution value is at risk of being diminished by future investment returns.

Given there is no upper limit to the dollar value of a TRIS commenced prior to moving to the retirement phase, because a TRIS in accumulation phase is not subject to the transfer balance cap, the 10 per cent maximum withdrawal can also be beneficial.

One of the considerations when contemplating using recontribution strategies is going to be an individual’s total superannuation balance. Members with less than $1.66 million in total super have no restriction other than the current $360,000 cap over three years.

Example

If we consider Carol, 60, with a balance of $2.5 million, she could start drawing the maximum out of her TRIS of up to $250,000 in the first year and recontribute it. She could then commence a second TRIS for $250,000 and then repeat the cycle.

The effect is that in one year, based on the same numbers, Carol’s fund has gone from 100 per cent taxable to 90 per cent taxable and 10 per cent tax-free. The following year she could take the maximum from the taxable pension and minimum from the one that is tax-free and this would significantly impact her SMSF for estate planning purposes, although in year two and three her recontribution would be limited.

Failing the pension standards

So while there are definitely opportunities for using a TRIS, seeing the new preservation age and the stage three tax cuts make them attractive to some members, it should be noted part of this article was dedicated to failing the minimum standards as a result of the update to TR 2013/5. This ruling applies to TRIS as well and in actual fact is worse for TRIS because failing to pay the minimum or indeed paying more than the maximum is significant as the ATO could deem the fund to be illegally accessing preserved benefits.

Multiple TRIS may help partially overcome the minimum issue and conceivably the maximum for one of the income streams, allowing for the preservation of tax-free and taxable planning, but it will not take away the breach of the payment standards.