Justifying prospective strategies to break through asset segregation intricacies

“Segregation can be done to separate the assets between accumulation phase interests and retirement phase interests for the purposes of determining the income of the fund that is exempt from tax,” Mr Miller said.

“Where an SMSF is intending to use segregation for claiming exempt current pension income and calculating their income tax, they will need to ensure they are eligible each year based on the disregarded small fund asset rules.”

But Mr Miller said without proper consideration of the requirements, the tax outcome and ultimately the additional expense may be undesirable.

“The choice to use segregation should be justifiable and, like most things, proper prospective planning is key,” he said.

The most common type of segregation that leads to the greatest misunderstanding and has historically been the subject of misuse is asset segregation at the fund level for the purposes of claiming exempt income, according to Mr Miller.

“At this level, the assets of the fund are traditionally segregated by accumulation phase interests and retirement phase interests,” he said.

“A key to this type of segregation is to ensure that the assets are appropriate to the pool they are allocated to — i.e. retirement phase assets will need to have higher income and/or be more liquid to meet pension payments compared to accumulation phase assets, which can potentially be more long-term growth assets.”

While not exhaustive, when thinking about the reasons of why SMSFs and members may choose to segregate, Mr Miller said to consider segregating at the fund level, which can be useful for funds with members in different life stages with different investment objectives/requirements and income needs.

From a member-level view, Mr Miller said fund-level segregation may often look like member-level segregation because one member is in the retirement phase and another is in accumulation phase; however, member-level segregation is distinct from fund level as it usually is representative of investment objectives rather than tax exemption.

“At the member level, the assets are segregated by member accounts but may also be broken down further into specific member interests such as pension versus accumulation interest. Ultimately, each member has their own pool of investments tied to their overall member balance,” he said.

“This may be the result of their investment preferences, investment horizon and risk tolerance being different to the other members of the fund.

“Segregation at the member level can be useful for members with different investment preferences and risk profiles.

“They may simply want to keep their finances separate albeit within the same SMSF. It can be for tax purposes for funds with accumulation phase accounts that are also paying retirement phase income streams to enable them to determine the exempt current pension income without needing an actuarial certificate.”

Diving into segregation complexities 

As understood, earnings on assets supporting retirement phase income streams are generally tax-free and this is known as exempt current pension income (ECPI).

Mr Miller said since the introduction of the transfer balance cap, there are less funds that are 100 per cent in the retirement phase and who now need to consider what method they will use to calculate the ECPI of their fund each year.

“The segregated method is one such method to calculate the amount of ECPI an SMSF can claim. All income from segregated current pension assets is ECPI. ECPI does not include either assessable contributions or non-arm’s length income (NALI) received by the fund,” he said.

“Segregated current pension assets are assets that are identifiable and have as their sole purpose supporting the payment of retirement phase income streams. When a capital gains tax event takes place in relation to a segregated current pension asset, both capital gains and capital losses are disregarded.”

But when considering deemed or elected segregation, Mr Miller said where all interests in an SMSF are retirement phase income streams, then all fund assets are held solely to support retirement phase income streams.

“In this situation, 100 per cent of the fund is in the retirement phase. All of the fund’s assets are considered to be segregated current pension assets, [and] unless they are disregarded small fund assets, the ATO has determined that these assets are deemed to be segregated,” Mr Miller noted.

“However, under the current rules, a fund may need to switch methods of calculating ECPI to the proportionate/unsegregated (actuarial) method during the year where there are periods where both retirement phase income streams and accumulation phase interests are held. As a result, deemed (or forced) segregation can create administrative issues for a fund having to use two methods for calculating the tax exemption for one year.”

Implementation and alternatives

Once it has been determined that segregation is appropriate to use for the SMSF and there are no restrictions on the fund proceeding, Mr Miller outlined that for any SMSF decision, the first step is generally to check the trust deed. 

“We need to ensure there is nothing specifically preventing segregation in the SMSF,” he said.

Mr Miller said the next step is to check the SMSF assets and ensure they can be appropriately split at the fund or member level depending on what approach is being used.

“If there is a large bulky asset that cannot be split across the fund/member pools, then segregation may not be possible (such as property — you cannot segregate part of an asset),” he said.

“After, list each asset and which pool it is allocated to ensure all assets are accounted for and make up the necessary pool balance. Review and update the fund’s investment strategy to ensure it is appropriate to the segregation method and each member’s preferences.”

Finally, funds should ensure the accounting records are revised to reflect the segregated pools and make sure any separate bank accounts are established where required, Mr Miller noted.

“The assets must be clearly identified and there must be a clear relationship between the assets and the member’s account,” he said.

When considering the alternative to segregation in an SMSF, Mr Miller said the approach is to have unsegregated assets and use a proportionate approach, referred throughout as the actuarial method. 

“Under this approach, there are no specific assets supporting the retirement phase income streams. In determining the income tax exemption applicable to the fund, where there are accumulation and retirement phase interests during the year, an actuarial certificate will be required,” he said.

“This may be of benefit in the long term if the dependants of the current members join the fund. This is in contrast to segregated funds where all capital losses on segregated current pension assets are ignored.

“Pooling the member accounts may also give the SMSF greater investment opportunities for larger assets. Where bulky assets are held, such as property, they may not be able to be segregated between member accounts, and this is not an issue under the unsegregated method.”