Once you are over the age of 60, pensions from a regulated superannuation fund generally provide a tax-free income stream whereas income derived from an investment outside the super environment is taxed at your marginal tax rate. The taxable component of a pension received after attaining your preservation age (generally 55 years if born before 1 July 1960) is taxed and a 15 per cent tax offset applies.
Take advantage of the proportioning rule
Broadly, the proportioning rule requires that a member’s superannuation benefit is split between a taxable and tax-free component that must be paid out in the same proportion as the taxable and tax-free components of the member’s interest in the SMSF.
The proportion of taxable and tax-free components for a pension is calculated when the pension is commenced, therefore a pension will lock in your tax-free component as a fixed percentage. In a rising market, this is very attractive as any returns on the pension’s investment will be allocated to the taxable and tax-free components in the same fixed proportion as when the pension started.
In accumulation mode, however, the tax-free component remains nominally static, so when the accumulation balance increases, the tax-free component is diluted and the percentage is reduced.
Thus, locking in a pension sooner rather than later in a rising market is generally more tax efficient. Moreover, prior planning to maximise the tax-free component by making non-concessional contributions (subject to the contribution caps) prior to starting a pension is popular for this reason.
Amalgamation – tips and traps
Given the ongoing changes over the past 10 years, there are many members who have more than one pension. They could have multiple pensions with different proportions of taxable and tax-free components. Also, under the Superannuation Industry (Supervision) Regulations 1994 (Cth), different pensions, such as lifetime pensions, allocated pensions, flexi-pensions (commutable lifetime pensions), fixed term and market linked pensions, may need to be treated differently.
People with multiple pensions often seek to simplify their affairs by combining several pensions into one. Moreover, there may be the opportunity of converting an old pension to a modern style pension. For instance, many people have, from mid-2007, converted their allocated pensions to account-based pensions. Others have converted lifetime and fixed-term pensions to market linked pensions. Naturally, expert advice should be obtained before converting any pension due to the superannuation, taxation, financial, social security and estate planning consequences. This generally involves rolling pensions back into accumulation and then starting a new pension.
Other considerations
Also, before you jump in and start rolling pensions back, here are a few things to consider:
- Zero accumulation balance – In order to prevent blending the proportions of various pensions’ taxable and tax-free components, it is important that SMSF members generally first exhaust their accumulation balance before rolling-back a pension. This allows the amount rolled back to be kept as a separate superannuation interest.
- Have thorough and complete documentation – Individuals should ensure that their pension documents show all the rules and provisions of their pension. The Superannuation Industry (Supervision) Regulations 1994 (Cth) require each requirement of the pension to be included in the pension’s governing rules. In addition, the Corporations Act 2001 (Cth) requires that any new pension interest has a product disclosure statement (PDS) unless it falls under the exemption in s 1012D(2A). Even if an adviser has explained the pension rules in detail, it is still important to be issued with a PDS specific to the pension.
- Be aware of caps! – Often, after rolling-back pensions a member who has reached their preservation age might like to top up their accumulation balance before starting a new pension. This has the effect of increasing the tax-free component of their accumulation balance, which is then locked in once they commence their new pension. However, and this cannot be stressed enough, when withdrawing and re-contributing be careful to not exceed caps for fear of getting hit with a maximum 93 per cent tax!
- Use the pensions with the highest taxable components first. Using up any pensions with higher taxable components during one’s lifetime to leave tax-free or low-taxed pensions for the longer-term is generally a good strategy. When you die if your pension is not reversionary its balance will typically return to accumulation mode (this can also happen even if you have nominated a reversionary beneficiary under a reversionary pension, see below). This means that any capital gains realised by the trustee to pay a lump sum will be taxable inside the fund as they are no longer (after the member’s death) covered by the pension exemption. If you have used up all of your pensions with taxable components, and all that remains are pensions that have high tax-free components, the taxable component on death is reduced.
Typically, if there is no surviving spouse, and adult children receive a lump sum, 16.5 per cent tax applies to the taxable component of a lump sum superannuation death benefit.
The impact of bankruptcy
Pension payments are treated as income and as such only receive partial protection from creditors. In comparison, under the Bankruptcy Act 1966 (Cth) an interest in a regulated superannuation fund or a lump sum paid after the date of bankruptcy is fully protected.
The flexibility of account-based pensions to draw down any amount of pension (subject to a minimum amount) has its advantages; however, these advantages can be a double-edge sword when a person is financially stressed. If you become bankrupt, your pension is only partly protected up to a modest income level (eg, an adult with two dependants $58,443.75). If your SMSF’s deed does not have adequate provisions to protect you in such a case, a trustee in bankruptcy can potentially step into the bankrupt’s shoes as a member and request the SMSF trustee payout your entire pension. In particular, any pension payment above the threshold is exposed.
