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Managing timing challenges in partial commutation affecting pension strategy

Meg Heffron
Tony Zhang
28 October 2021 — 3 minute read

Whilst pensions can run for many years, the use of partial commutation can work differently with how timing can interact with the rules as it can affect other aspects of the funds, such as transfer balance cap and EPCI considerations.

In a recent technical update, Heffron managing director Meg Heffron said that partial commutations are in fact very common as any commutation from a retirement phase pension (i.e. one that has counted towards the member’s transfer balance cap) is treated like a partial reversal of the amount of cap that has been used up.

“In other words, someone who started a pension with the full $1.7 million transfer balance cap amount but then takes a partial commutation of $100,000 is regarded as having used up only $1.6 million of their cap. They can top back up to $1.7 million in the future by starting another pension with up to $100,000,” she said.

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“This ability to create some ‘space’ in the transfer balance cap is extremely useful for people who later make downsizer contributions or inherit a pension from their spouse’s super. For that reason, it’s a common strategy for people with large pension balances to take the minimum amount each year as a normal pension payment but treat any other payments as ‘partial commutations’.”

However, unlike a full commutation, it’s not necessary to make sure payments are up to date first. But if they’re not, Ms Heffron said the trustee has to make sure that there is enough left in the pension account after the partial commutation to still make the full year’s pension payments.

“Remember that the full year’s payments still have to be paid even after a large partial commutation,” Ms Heffron noted.

“There’s no process to reduce the payments required for the rest of the year even if the commutation represented the vast majority of the account. It’s why it pays to be careful when taking a large partial commutation and converting it to a new pension – the member may effectively end taking pension payments on the same money twice (a full year’s payment from the original pension and then a minimum payment from the new pension).”

This also leads to considerations that the partial commutation itself doesn’t count towards the minimum pension calculations. Ms Heffron observed it is, therefore, possible to take a huge amount of money out of a pension and yet still fail the minimum payment requirements.

“Bear in mind also that partial commutations can be paid via asset transfers (in specie) whereas pension payments have to be in cash,” she explained.

“This can be another reason for treating some payments as commutations – it allows assets to be transferred out of the fund in lieu of a cash payment to the member.

“Full commutations can create big tax problems. It is because a full commutation means switching off the fund’s entitlement to a tax exemption on investment income (exempt current pension income, ECPI) as soon as the trustee agrees to the commutation.

“Where the fund is claiming its tax exemption using the ‘segregated method’ rather than getting an actuarial certificate, this will mean that all the income earned after the pension ends is taxable – potentially capturing a lot of capital gains.”

But the treatment for partial commutations is quite different. No matter how large the partial commutation, it never causes the pension to end and hence ECPI continues, according to Ms Heffron.

“This is why people wanting to wind up their pension and transfer out all the assets (to themselves or to another fund) will often do this in two steps which include a large partial commutation of all the assets with capital gains, so that the gain occurs while the fund is still receiving a tax exemption, followed by paying out the remaining cash as a separate transfer or pension payment, she explained.

Like full commutations, partial commutations also require a Transfer Balance Account Report (TBAR). Practitioners must remember that in an SMSF, if a partial commutation is rolled back into accumulation phase (rather than cashed out or transferred to another fund), it will mingle with any money already sitting in the member’s accumulation account, according to Ms Heffron.

“Most of the time, a partial commutation is paid directly out of the fund, in which case this isn’t a problem. But if it’s left in the fund, mixing with the accumulation account will also mean mixing the tax components. Like eggs, they can’t be unscrambled,” Ms Heffron said.

“The ability to partially commute a pension is hugely valuable and is often used to treat larger payments more strategically. But it pays to understand the rules.”

Tony Zhang

Tony Zhang is a Journalist at SMSF Adviser, which is the leading source of news, strategy and educational content for professionals working in the SMSF sector.

Since joining the team in 2020, Tony has covered various publications across the legal, financial and professional services sectors including Lawyers Weekly, Adviser Innovation, ifa and Accountants Daily.

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