Avoiding curveballs with the super reforms
As SMSF practitioners begin to apply some of the government's superannuation changes, some of the trickier aspects of the legislation have started to surface.
Much has been written about the government’s superannuation changes, in particular the $1.6 million cap on the transfer into the tax-free retirement phase. The legislation shows how the government wants the cap to work in practice and flags what SMSF trustees should be aware of ahead of its introduction on 1 July 2017.
The transfer balance cap in brief
Under the legislation, trustees who don’t already have a pension account can transfer a maximum of $1.6 million from their accumulation accounts into pension phase once they retire. This applies as a total across all super accounts and not per fund. There will continue to be no limit on the amount that can be held in an accumulation account that is taxed concessionally at 15 per cent.
Everyone starts 1 July 2017 with a transfer balance cap of $1.6 million. As monies are transferred into the pension phase, those amounts will apply against this cap. Your clients’ transfer balance will be indexed proportionately each year in line with the overall transfer balance cap. For the purposes of the cap, defined benefit pension interests will be valued based on special rules outlined in the draft legislation, which is expected to be the annual payment multiplied by a factor of 16.
If your clients already have a pension account at the start date, you will need to determine the total value of their pension interests and assess this against the transfer balance cap. If the balance is less than $1.6 million, they can use any remaining cap to transfer more capital into the pension phase in the future. If the value of their pension interests is greater than $1.6 million at the start date, they will be required to withdraw the excess either by rolling back to accumulation phase or withdrawing the excess from superannuation, or a combination of both. If part of the pension interest is made up of a defined benefit pension, as these are non-commutable any pension amounts rolled back must come from the account-based pension balances.
After 1 July 2017, pension balances in excess of the cap can be subject to an excess transfer balance tax. This will initially be the 15 per cent tax that should have been paid on earnings had the money been in the accumulation phase, but based on notional rather than actual earnings. The penalties become more punitive if they are not rectified in good time.
The legislation recognises that commuting exactly the right amount to bring the pension balance under the cap immediately on 1 July 2017 may be difficult. As such, there is a grace period where amounts of up to $100,000 over the cap will not incur the excess transfer balance tax, provided the breach is rectified within six months. This doesn’t give a lot of time to finalise 2017 accounts to determine 30 June 2017 pension balances.
Relatively generous transitional arrangements regarding capital gains tax means much of the panic over realising significant gains ahead of the new regime is likely to be unwarranted. In effect, the provisions allow SMSF trustees to reset their cost base on assets currently supporting pensions on 1 July 2017. This means that funds will not have to pay capital gains tax on capital gains made on these assets prior to the start date should they have to roll them back to accumulation phase to meet the new cap.
How to apply the capital gains tax relief
Since all fund assets will be affected by the requirement to comply with the $1.6 million cap due to being unsegregated from 30 June 2017, CGT relief will be eligible for all fund assets. However, SMSFs do not have to apply this relief.
As the CGT relief is not automatic, funds will apply for the relief for each chosen asset in the approved form guidance forthcoming at 30 June.
Each asset to which the relief is applied will have gains locked in at 30 June and the 2016-17 financial year tax-exempt percentage applied to them. The cost base of each asset is reset to the current market value and this is irrevocable. Assets to which the relief is not applied will not have their cost base reset.
Where SMSF trustees have pension phase assets greater than $1.6 million, they will effectively have two choices:
- Commute the excess from pension back to accumulation phase, keeping the assets in the fund but now subject to a 15 per cent tax rate on earnings; or
- Withdraw the excess from superannuation and invest it outside of super where earnings will be taxed at the individual’s marginal tax rate (or alternative tax arrangement).
The tricky aspect of this decision is that once they withdraw the money from super, there may be very limited capacity, if any at all, to get the money back in. This will often be an irreversible decision.
From a tax perspective, it looks relatively easy to assess whether they will be better off having these excess assets in super paying 15 per cent on earnings versus outside of super at their marginal tax rate. However, offsets available to pensioners can often make effective tax rates lower than marginal rates. The gradual withdrawal of these offsets can also make the marginal tax rate significantly higher for certain income bands. To further complicate the decision, what is better today may not be better down the track, depending on investment performance, spending decisions and legislative changes.
Trustees will need to weigh up their options and make a choice before the start date. If the decision is to keep assets in superannuation, which for those on the highest marginal tax bands may be reasonable, it will be useful to re-assess this regularly and move assets outside super if non-superannuation assets decrease and there is capacity within the generous personal tax offsets to accommodate greater income without paying additional tax.
Placing assets in accumulation versus pension
Many SMSF trustees will be thinking about which assets to place in accumulation and which in pension to obtain the best tax outcome. However, where an SMSF has a member with super assets in excess of the cap, in any super fund, the SMSF will not be able to segregate assets for tax purposes. This means that all the fund’s assets are assumed to be held in one unsegregated pool.
The government has introduced this new measure to stop funds from cycling assets between segregated pools for each phase to avoid capital gains tax. It’s worth noting that assets can still be notionally allocated to different members or accounts to adopt different investment strategies.
For those likely to have clients with super balances at or over $1.6 million by 1 July 2017, there is plenty to think about, and it’s important to understand the rules and plan well before next financial year.
Doug McBirnie, senior actuary, Accurium