Changes to the taxation of income streams

The reform package will result in the largest change to the superannuation system since the Simpler Super changes in 2007, so it is imperative accountants and financial advisers understand how the changes might impact their client’s tax position or retirement plan.

One area that has caused confusion are the changes to the taxation of income streams at both super fund and member levels, specifically the $1.6 million transfer balance cap.

$1.6 million transfer balance cap

From 1 July 2017, a new transfer balance cap will apply to limit the amount of benefits a client can transfer from the accumulation phase to the tax-free retirement phase.

Income streams that will count against the transfer balance cap include all ‘retirement phase income streams’ which include superannuation pensions and annuities. Not included are transition to retirement income streams and non-commutable allocated pensions and annuities.

Broadly, the balance of existing retirement phase income streams at 30 June 2017, as well as the initial value of new income streams commenced on or after 1 July 2017, will be measured against an individual’s personal transfer balance cap. Any amount in excess of the cap will need to be rolled back to accumulation phase or withdrawn from the superannuation system.

General transfer balance cap

The general transfer balance cap for 2017-18 will be set at $1.6 million and will be indexed annually in line with increases in the consumer price index in increments of $100,000.

Personal transfer balance cap

The personal transfer balance cap determines the amount that a client can transfer into retirement phase income streams. The personal transfer balance cap initially equals the general transfer balance cap in the year they first commence a retirement phase income stream. However, over time, the personal transfer balance cap may differ from the general transfer balance cap due to proportional indexation. Proportional indexation is based on the value of any increase in the general transfer balance cap and the unused proportion of their personal cap.

Example

Glenda retires on 1 July 2017 and immediately commences a $1.2 million account-based pension. As Glenda commenced her first retirement phase income stream in 2017–18, her personal transfer balance cap is equal to the general transfer balance cap of $1.6 million. In this case, Glenda will have used 75 per cent of her personal transfer balance cap and will have an unused cap proportion of 25 per cent.

On 1 July 2019, the general transfer balance cap is increased by $100,000 to $1.7 million due to indexation. Assuming Glenda has not commenced any other retirement phase income streams in the interim, her personal transfer balance cap will be increased by $25,000 ($100,000 × 25 per cent) to $1.625 million. In this case, Glenda will then have $425,000 of her personal cap remaining.

Transfer balance accounts

To determine when a client has exceeded their personal transfer balance cap, a transfer balance account system will be implemented that will work like a general ledger, with amounts credited and debited depending on a client’s circumstances.

Amounts credited to transfer balance accounts

The following amounts are required to be credited to a client’s transfer balance account:

• The value of all of a member’s existing retirement phase income streams as at 30 June 2017.

• The commencement value of new superannuation retirement phase income streams commenced on or after 1 July 2017.

• The value of reversionary superannuation income streams as at the time the individual becomes entitled to them (note – a modification applies to defer the time at which a credit arises, see below for more information).

• Where a member has exceeded their transfer balance cap at a time, an amount of notional earnings on the excess amount.

The value of a retirement phase income streams that will be credited to a member’s transfer balance account will depend on the type of income stream paid.

For account-based income streams (other than market-linked income streams):

• Where the income stream commenced prior to 1 July 2017 – the value of the income stream account balance on 30 June 2017; or

• Where the income stream commenced on or after 1 July 2017 – the commencement value on the start day.

For certain non-commutable defined benefit income streams (known as capped defined benefit income streams[1]), the value of the income stream is determined by multiplying the member’s annual income entitlement by a pension valuation factor.

• For lifetime pensions or annuities – the client’s annual income entitlement × 16.

• For term and market-linked income streams – the client’s annual income entitlement × number of years (rounded up to the nearest whole number) in the remaining term.

Timing of credit for reversionary pensions

Where an income stream automatically reverts to a nominated beneficiary on the death of the original recipient, the value of the pension, as at the time of death, will count as a credit to the beneficiary’s transfer balance account.

However, to give the beneficiary time to arrange their affairs, the credit will be deferred and will not arise in the beneficiary’s transfer balance account until 12 months from the date of death.

This rule applies where a pension reverted to a member’s beneficiary on or after 1 July 2016. For example, where a pension reverted to a member’s beneficiary on 1 January 2017, a credit will not arise in the beneficiary’s transfer balance account until 1 January 2018.

Where a beneficiary receives a reversionary pension that reverted prior to 1 July 2016, the balance of the reversionary pension at 30 June 2017 will count as a credit to the beneficiary’s transfer balance account.

Amounts debited from transfer balance accounts

The following amounts will act as debits from a client’s transfer balance account:

• The value of any lump sums commuted from a retirement phase income stream (including where the commutation results in a negative transfer balance account value).

• The value of any structured settlement contributions.

• The value of any replenishment debits approved by the ATO.

It is important to note that pension payments and negative investment returns do not count as debits. Therefore, the value of a client’s retirement phase pension, such as an account-based pension, could be quite different from the value of their transfer balance account where a client’s account balance has been eroded by negative investment and/or pension payments.

Impact of a rollover on a client’s transfer balance account

Where a client fully or partially commutes a retirement phase income stream, the value of the commutation will be debited from their transfer balance account and can result in a negative transfer balance account value.

This ensures that a client is able to roll over the full value of any retirement phase income stream to another provider even where their pension balance has grown due to investment returns and now exceeds their personal transfer balance cap.

Example

Diego commenced an account-based pension with $1.6 million on 1 July 2017, fully using up his personal transfer balance cap. In 2020, his account-based pension balance has grown to $1,750,000 due to strong investment returns. He then commutes his pension and rolls over the lump sum to another provider and commences a new account-based pension.

In this situation, Diego’s transfer balance account would have the following entries:

Year

Credit/Debit

TBA Balance

2017-18

Credit $1.60m

$1.60m

2020-21

Debit $1.75m

-$150,000

2020-21

Credit $1.75m

$1.60m

Consequences of exceeding the transfer balance cap

Where a client exceeds their personal transfer balance cap, the amount of the excess plus a notional earnings amount will be required to be commuted and removed from the retirement phase. In addition, the client will also be required to pay excess transfer balance tax on the amount of notional earnings.

Notional earnings on an excess transfer balance amount will be calculated at the general interest charge rate for the period starting when the client commenced to have an excess amount and ending when the amount is removed from retirement phase. Excess transfer balance tax will apply to notional earnings at the following rates:

• For assessments during the 2017–18 financial year – 15 per cent.

• For assessments from 1 July 2018 – 15 per cent for the first assessment and then 30 per cent for subsequent assessments.

Where a client breaches their transfer balance cap on 30 June 2017 by less than $100,000, the excess amount will be disregarded for a period of six months. However, this transitional rule will only apply where the excess amount is removed from the retirement phase by the end of the six-month period.

Excess transfer balances

Clients who are members of large funds with retirement income stream balances over $1.7 million will therefore need to take action in the lead-up to the end of the financial year to reduce the combined value of their income streams to no more than $1.6 million by 30 June 2017.

However, where a client is a member of an SMSF, they may not know the value of their retirement phase income streams until several months after the end of the financial year when the fund’s annual return is completed. In this case, members will need to estimate the amount that needs to be commuted by 30 June 2017 and once the actual balances are known, make further commutations if necessary. Under the transitional rules, as long as they do not exceed the transfer balance cap by more than $100,000 and they commute the excess within six months, the excess amount will be disregarded.

[1] Capped defined benefit income streams include complying lifetime pensions commenced either before or on or after 1 July 2017, or the following types of income streams commenced prior to 1 July 2017 – complying lifetime annuities, complying term pensions and annuities, complying market linked pensions and annuities.

Craig Day, head of technical services, Colonial First State