Recent ATO rulings and interpretations emphasise the need to understand the rules about paying account-based income streams and transition to retirement pensions.
The pension standards in the Superannuation Industry (Supervision) Act and regulations (SIS Act and Regs), which have been there for many years, are a precursor to whether the fund will qualify for tax exemption for income earned on investments that are supporting the pension. The exempt income on pension investments is called Exempt Current Pension Income (ECPI) and Subdivision 295-F of the Income Tax Assessment Act 1997.
There are many types of pensions described under the SIS regulations. However, these days all SMSFs, with very few exceptions, can only begin account-based pensions and transition to retirement pensions (TRIPs). In a very small number of cases SMSFs are paying complying lifetime and life expectancy pensions as well as market-linked pensions due to the grandfathering rules that began in 2007. Whatever type of pension the SMSF pays, if the appropriate rules are not met the consequences will be the same – tax is payable on income earned from investments that support the failed pension.
First, let’s look at an account-based pension that fails to meet the rules and then compare it with a transition to retirement pension that does exactly the same thing. Under the rules for an account-based pension there are three essential rules that must be satisfied. Don’t comply with one of these rules and it’s the firing squad for the pension.
Rule 1 is to ensure the pension meets the minimum payment requirements published in Schedule 7 of the SIS Regs. Rule 2 is the pension can only be transferred to another only on the death of the primary or reversionary beneficiary. And Rule 3 is to ensure the capital value of the pension and income earned from it are not used as security for a borrowing.
It is reasonable to expect that Rules 2 and 3 are relatively easy to comply with as it would be unusual for a pensioner to transfer the pension to another person while they were alive, or deceased for that matter, and very unlikely for the pension to be used as security for a loan as those days are well and truly over.
However, in relative terms not paying the minimum pension, especially from an SMSF, would be more common for a number of reasons. In some cases clients may be well off and decide not to draw any pension, some may draw amounts from the fund on an ad hoc basis and not draw enough, while others may just fall short due to small miscalculations of the payment dates, valuation of the fund’s investments and similar events.
In a case study let’s assume that a member of an SMSF, Julia, who is age 62, has used all her balance of $800,000 to begin an account-based pension. Each year she will be required to draw at least four per cent of her account balance from the fund calculated at the time the pension began (pro-rated on a daily basis) or at the start of the financial year. If the pension began on 1 July in the financial year the minimum drawdown amount will be $32,000. If only $20,000 was drawn as a pension from the fund it would not meet the minimum requirements. In view of this the pension will not meet the minimum requirements.
If the pension balance of $800,000 earned $96,000 for the year it now would be taxed at 15 per cent and tax of $14,400 would be payable rather than being tax free if the minimum pension requirements had been met. In addition, the drawdowns received by Julia will be treated as lump sums. On 1 July 2016, if she wishes to continue to receive a pension from the previous balance, new calculations will need to be made as the tax commissioner treats it as an entirely new pension from the start of the next financial year.
Let’s look at the consequences if the pension Julia was drawing from her fund was a TRIP. To qualify as a TRIP Julia must have reached her preservation age and continues to work as well as not meeting a condition of release. As Julia is 62 she is older than her preservation age of 55 and continues to work full time, meaning that she has not met a condition of release. If we assume that Julia began a TRIP with her balance of $800,000 and all the components are preserved let’s see what happens.
If the TRIP began on 1 July 2015 Julia would be required to draw down a minimum pension of at least $32,000 and as TRIPs are subject to a maximum drawdown amount, could not take any more than 10 per cent of the balance ($80,000) each year. There are also restrictions on TRIPs that ensure Julia could not withdraw a lump sum from her TRIP balance until she meets a condition of retirement such as permanent retirement or reaches age 65, whichever is later.
If we assume that Julia has only drawn down $20,000 as a TRIP she will not meet the minimum payment requirements. This means that the income earned on the investments used to support the pension will be taxed in the fund at 15 per cent. In addition, the commissioner will treat the amounts drawn down on the failed pension as a series of lump sums. However, unlike the treatment of the withdrawals from the account-based pension that will remain tax free in Julia’s hands, the series of lump sums from the TRIP will be taxed at full personal rates as they are considered to be in breach of the preservation standards. This applies irrespective of Julia’s age in the case of the drawdown of any preserved components.
Despite all this, the commissioner may be kind enough to overlook the underpayment of the account-based pension or TRIP where an honest mistake has been made that has resulted in a small underpayment or the reason for the underpayment was outside the control of the fund trustees. In these cases a payment is required to be made as soon as possible. A small underpayment of the minimum is where it is no greater than a 12th of the minimum pension required to be paid. Circumstances beyond the control of the trustees would include genuine errors in calculation that resulted in the underpayment or an error by a third party such as a financial institution.
So there you go; make sure your clients meet all the requirements of paying an account-based pension or a TRIP otherwise they may end up with an unexpected tax bill as well as the need to restructure the income stream in the financial year following the failure of the pension. One of the simplest ways of ensuring the minimum pension is paid for the year is to have a direct transfer of money from the SMSFs bank account on a regular basis.
Thursday 7 May 2015
Columnist: Graeme Colley, director of technical and professional standards, SMSF Association