As we enter the last quarter of the financial year, SMSF advisers and trustees turn their minds to compliance and year end strategies.
One of the key issues that typically arise in this quarter is the payment of minimum pensions. SMSF advisers must ensure trustees meet the minimum pension payments prior to 30 June, or risk the income of their fund being taxable.
The exempt current pension income (ECPI), the deduction the SMSF obtains for paying pensions to members, is available for compliant account-based pensions. This deduction effectively renders the investment income of the SMSF assets used to fund a pension non-taxable.
For SMSFs running transition to retirement (TTR) pensions, the effect of not paying a minimum pension can be worse than normal account-based pensions.
Generally, recipients of a TTR pension have not yet met a condition of release which allows them access to their super. Paying a pension that does not meet the minimum for the year actually results in a breach of the Superannuation Industry (Supervision) Act, with the member having gained illegal early access to their super. The penalties for such oversights can be extreme, from directions to the trustees to undergo education to the fund being made non-complying.
Some funds struggle to meet the minimum pension due to cash shortfalls. This usually occurs in an SMSF with large illiquid assets such as property. Pensions must be paid with cash, and one of the key problems with illiquid assets in drawdown phase is can be the lack of cash to meet pensions. Active management of cash flow and asset allocation becomes even more important in the pension phase of an SMSF.
The situation for lump sum payments is different, as such payments can be made via the in-specie transfer of assets to a member. Key requirements of the Superannuation Industry (Supervision) Act must still be complied with, such as the asset being transferred at its market value.
If there are liquid assets, trustees may not be willing to sell those assets to provide cash to meet pensions if they deem them to be undervalued. In this instance, there is a solution for advisers to implement.
Partial commutation lump sum strategies
Lump sum payments can be counted towards the minimum pension, so long as the lump sum is a partial commutation of the pension. This allows advisers to implement a partial commutation lump sum strategy, with the lump sum payment made via the in-specie transfer of an asset to the member in question. The lump sum amount counts towards the minimum and the trustee has not been forced to sell an asset – the member would benefit from any subsequent increase in value of the asset.
The treatment of the payment as a lump sum must be requested by the member in advance of the payment, and advisers should ensure trustees’ minute their actions to ensure there is no ambiguity as to how the value transfer will be treated. The ATO’s SMSFD 2013/2 has a multitude of examples to assist trustees and their advisers to ensure appropriate documentation is in place.
For advisers considering implementing a partial commutation lump sum strategy on behalf of clients to ensure minimum pensions are met, it is important to first consider whether the member is entitled to receive a lump sum payment. If they have not met a condition of release, then they must have some unrestricted non-preserved benefits in their member pension account to be able to enact the strategy. If not, they will not be able to legally take a lump sum payment from their pension account.
Another key issue to consider is the effect on a member’s Centrelink benefits when making extra pension payments.
Pensions not grandfathered to the pre-1 January 2016 income test rules would not be affected, as such pension accounts are subject to deeming rules. However, for those grandfathered, the payment of a lump sum instead of pension reduces the future deductible amount. It may be more appropriate to commute the pension and restart a new pension under the deeming rules.
If an SMSF does not have sufficient cash or liquid assets to meet the minimum pension, and if the member has met a condition of release, advisers need to consider the consequences for trustees not meeting the minimum pension in that year. The investment income attributable to that member account would be taxable instead of tax free; however, that may not be a big problem depending on the fund size and member account.
For those who miss paying the minimum pension by a small amount, there is some relief. If the failure (to pay the minimum pension amount) is due to an honest mistake and the amount is less than one 12th of the minimum pension payment, then the ECPI of the SMSF will be safe – so long as the trustee makes up the minimum payment.
Also, if the failure is due to matters outside of the control of the trustee then the SMSF will still be able to claim the ECPI.
The catch-up payment must be made by the trustee within 28 days of becoming aware of the underpayment and is counted towards the minimum pension in the year to which it relates, not the year in which it is paid.
Even though 30 June may seem like a while away, it has a way of sneaking up on you. By starting to prepare now, advisers can ensure clients meet the minimum pension payments ahead of time and avoid additional tax.
Chris Morcom, director, Hewison Private Wealth