Underpaying your SMSF pensions can have costly consequences

“If you think that underpaying your account-based pension or any other type of pension from your SMSF is not a problem, then you need to think again,” he said.

In the case, the amount received in the breach was taxed at personal income tax rates just like salary and wages, without any exemptions or tax offsets.

Mr Colley said the ATO has made its position clear and has stated that where an SMSF fails to comply with any of the pension rules in the SIS Act and regulations there will be consequences which will go much further than just topping up the pension payment to the required minimum.

“Any breach also impacts the amount of tax payable by the fund and the treatment of each payment in the year of the breach,” he said.

“Where a pension is found to be in breach of the rules, it is treated as ceasing from the commencement of the financial year in which the breach occurred. All payments made from the pension during the year are treated as a series of lump sums rather than the payment of an income stream.

“Also, any income earned on investments used to support the pension is taxed in the fund at 15 per cent rather than being treated as tax-exempt.”

It means that if, in the financial year after the breach has occurred the pension is treated as having ceased, it will be treated as an entirely new pension which may have tax implications for estate planning purposes, especially if adult children receive lump sum death benefits.

“This is because the underlying taxable and tax-free components of the benefit may change,” Mr Colley said.

He gave an example of how the rules may play out with a fictitious client called Christine, who is 65, retired, and the only member of her SMSF.

Christine commenced her first account-based pension on 1 July 2021 with a total fund balance of $1.7 million.

“The minimum pension required to be paid during the 2021/22 financial year was 2.5 per cent of the opening balance of $1.7 million on 1 July 2021, and the required minimum pension amount was $42,500. However, the SMSF made pension payments to Christine of $26,000,” Mr Colley explained.

When the fund accounts were being prepared in May 2023, Christine’s accountant and tax agent notified her that the amount of the pension paid to her for the 2021–22 financial year was less than the required minimum, meaning the fund was in breach of the pension rules from 1 July 2021 and that the pension was treated as ceasing from the date it commenced .

“Any amounts received by Christine will be treated as a series of lump sums rather than income stream payments. This will have an impact on the amounts reported for purposes of Christine’s Transfer Balance Cap; however, the amounts she received will continue to be tax-free in her hands,” he said.

“The income and taxable capital gains earned on the investments in Christine’s SMSF will now be fully taxed at 15 per cent rather than tax-exempt because where an SMSF has all its investments supporting pensions in the retirement phase, any income will be totally tax-exempt. However, where the pension breaches the rules, any income on investments is treated as if Christine’s SMSF is in the accumulation phase for the whole year.”

However, Mr Colley said there are some situations, if the underpayment of the pension is minor, the Tax Commissioner may be prepared to overlook the breach by exercising discretion under his General Powers of Administration.

“Discretion will be exercised, and the Commissioner will accept the pension as complying with the legislation where the underpayment is no more than 1/12th of the minimum amount required to be paid for the financial year,” Mr Colley said.

“For example, suppose Christine’s pension had been underpaid by no more than $3,542, which is 1/12th of her minimum pension for the 2021/22 financial year. In that case, the SMSF may have been able to rely on the Commissioner’s General Powers of Administration.”

But if the breach occurs in receipt of a transition to retirement income stream (TRIS) not in the retirement phase, the consequences differ slightly.

“A TRIS has a minimum pension percentage that is required to be met and a maximum pension percentage equal to 10 per cent of the balance at the beginning of the year,” Mr Colley said.

“A TRIS not in the retirement phase used to commence the TRIS is not counted against the person’s Transfer Balance Cap. Also, any income earned on the fund’s investments used to support a TRIS not in the retirement phase is taxed at 15 per cent in all cases.”

The main issue with breaching the pension rules for a TRIS not in retirement phase is that it will not be considered a pension for the whole year in which the breach occurred meaning any payments received by the member in breach of the preservation standards will be taxed at full personal tax rates without any tax offsets applying.

“The recent decision in the Appeals Tribunal taxed a member of an SMSF who received amounts from a pension in breach of the rules at full personal tax rates – something that should be avoided at all costs,” Mr Colley said.

As the last few weeks of the financial year come to an end, Mr Colley said it is important for advisers to check that any client in receipt of a pension from their SMSF has been paid at least the reduced minimum for this financial year.

“Anyone in receipt of a TRIS that is not in the retirement phase should check to ensure they have met the minimum payment requirement.”

“Also, they need to check they have not exceeded the maximum TRIS payment equal to 10 per cent of the account balance at the commencement of the financial year. Failing to meet any of these requirements may mean a lot more work when the accounts for the SMSF are prepared and explaining things to the fund’s auditor.”