After the Reformation: Strategies with SMSF income streams
Planning for the eventual passing of superannuation death benefit payments in the most tax-effective manner has, by necessity, changed following the superannuation reform changes from 1 July 2017, and subsequent ATO releases regarding the need to document the allocation of the payment of superannuation benefits to fund members.
SMSFs were not in existence at the time of the real Reformation, but the more recent Reformation, in the form of the Superannuation Reform legislation, certainly impacts many SMSF members in receipt of an account-based pension1.
What is the impact?
The introduction of transfer balance caps under the superannuation reform legislation caused many SMSF members and their advisers to review their pension balances and, if necessary, to partially commute their pensions to ensure the capital base (i.e. assets supporting the pensions) was no more than $1.6 million on or before 30 June 2017.
The impact was felt, at that time, by a significant number of SMSF members — those with pensions in excess of $1.6 million.
What happened to the rest?
The most common action in the days leading to 30 June 2017 was for resolutions to be drafted, following a request from the member, to:
- reduce the total amount of the assets supporting their pension (or pensions) to no more than $1.6 million on or before 30 June 2017; and
- deposit the excess amount to their accumulation account.
As a result, many SMSF members who had only pension accounts in their fund found they also had an accumulation account balance.
Post-1 July 2017
That impact referred to earlier continues to apply to fund members, meaning that the importance of ongoing consideration of available options remains.
As time has moved on from the start of the Reformation, the impact has spread further, in particular to fund members who have:
- met a condition of release and commenced an account-based pension; or
- have received a death benefit income stream as a result of the death of a super fund member.
In those instances, the transfer balance cap has determined the amount to be held in pensions and the amount remaining in accumulation or, for death benefits, paid out as a lump sum².
The need for similar actions as occurred prior to 30 June 2017 to be undertaken remains, including for a member who may receive a death benefit income stream in the future.
At the time, it may be necessary for them to create space in their transfer balance account by commuting some or all of their own pension to accumulation.
That changes the dynamics from a number of perspectives, including the estate planning which may have previously been undertaken by the adviser and the SMSF member.
Because of the “death benefit tax” which applies to the taxable component of benefits when paid to certain beneficiaries (such as adult children) following the death of a member, some planning exercises involved maintaining a separation of the two main components of member benefits — taxable and tax-free components — and SMSFs provided a degree of flexibility to enable that planning and structuring to occur.
Has that tax planning advantage been lost?
Not necessarily, but it requires a different consideration for people who have been impacted by the initial $1.6 million transfer balance cap. Note that, as the general transfer balance cap will increase to $1.7 million from 1 July 2021, some members will see their individual transfer balance cap increase to some extent from $1.6 million, while for others, their transfer balance cap will remain at $1.6 million.
For members who now hold funds in their SMSF in accumulation as well as pension accounts, a different form of planning may be more applicable.
Rather than treating the funds drawn from the SMSF only as pension payments, members may want to consider applying those drawings as part-pension and part-lump-sum payments, the latter being from the accumulation account in the fund.
If the accumulation account consists predominantly of taxable funds, for example, the advantage in drawing down accumulation funds is that, on the eventual death of the member, when their benefits are to be paid to adult children, the amount on which tax will be payable will have been reduced.
Also, if a member has multiple pensions, the total amount drawn in excess of the minimum could be applied to the pension with the higher taxable component, thereby reducing the potential death benefit tax at some point in the future.
How does that work?
Remembering the requirement that at least the minimum pension amount must be paid each year, there are two main options for those who have been forced to move funds from pension accounts to accumulation, or leave money in accumulation when commencing pensions, being:
- a two and possibly three-step process whereby whatever amount is paid to the member during the financial year is applied:
- firstly in payment of the minimum pension;
- secondly as a lump sum from accumulation (assuming the member is able to access accumulation funds); and
- thirdly, if the accessible portion of the accumulation balance has been exhausted, then from the partial commutation of a nominated pension, as a lump-sum payment³; or
- as above except the second step would not apply, meaning:
- firstly in payment of the minimum pension; and
- secondly from the partial commutation of a nominated pension, as a lump-sum payment³.
The decision as to which of the above options is most appropriate will depend on the taxable and tax-free components of the pension and accumulation accounts, along with other considerations applicable to the individual circumstances.
Can we decide on the application at the end of the financial year?
That would most likely give rise to a number of significant problems. Some examples include:
- potentially, the payments could be deemed to be pension payments in the absence of prior instructions to the contrary, therefore negating the planning undertaken; and
- the ATO requirement for “real-time reporting” will not have been met if partial commutation of pensions occurs, potentially resulting in financial penalties.
The ATO view is that the member should provide a request to the trustee before any benefit payments are made for the year.
The member’s request to the trustee should be in writing, so as to provide evidence that the application was properly made, and the request should be formally considered by the trustee.
Documentation for this purpose may include:
- a written request from the member to the trustee, detailing the structure and order of payments requested to be applied;
- resolutions of the trustee acknowledging the request and (presumably) deciding to agree to the request; and
- a letter from the trustee to the member conveying its consent to the request.
Planning opportunities are still available, but they necessitate a somewhat different thought process than that which applied prior to the Reformation.
Documentation evidencing the member request and trustee decision is a very important part of this process, and should ideally be implemented prior to payment of benefits.
1. For simplicity, this article will cover account-based pensions only.
2. Death benefits must only be retained in the fund in the beneficiary’s pension account, not their accumulation account. Any death benefits unable to be paid as a pension must be paid from the fund.
3. As superannuation legislation limits death benefit lump-sum payments to one interim and one final payment, partial commutations of a death benefit income stream may not be feasible.
Michael Harkin, national manager for training and advice, Topdocs