Underpaying account based income streams can mean trouble but underpaying a reversionary or death benefit income stream can mean even bigger trouble. You may end up paying unwanted tax and be left with the problem of getting the pension back into shape.
Underpaying account based income streams
So, you’ve retired and decided to commence an account based income stream. Starting one is pretty easy and make calculations based on the opening balance with a minimum income stream that depends on your age. Providing you pay at least the minimum amount things should go smoothly providing the fund has the cash flow.
But what happens if you end up with less than the minimum amount? If the income stream is underpaid each payment during the year is treated as a lump sum and the income and taxable capital gains on investments supporting the income stream are taxed at 15 per cent. If you intend to continue with the income stream in the next financial year, it means starting over again with new calculations and documents, all at a cost to your fund.
For anyone who underpays the minimum income stream by up to 1/12th of the required amount you may be saved from all the trouble of a restart. But it’s a once only opportunity and you need to make sure that the underpayment is made as soon as it’s discovered.
So, here’s an example of the downside of paying an account based income stream:
Gareth commenced an account based income stream with $600,000 when he retired at 63 on 1 July 2018. He would need to draw a minimum income stream of at least 4 per cent of the opening account balance, $24,000. Gareth decided to draw down half his income stream in December 2018 and the rest in June 2019.
The income stream payment for December of $12,000 was paid but as Gareth covered his living expenses from sources outside super, he decided not to draw anything further. It wasn’t until his annual visit to his accountant that he discovered the problem he had made for himself.
During the financial year, Gareth’s super fund had earned $42,000 and as the whole of his fund was in retirement phase it should have been tax free with a refund of all franking credits. However, as he did not withdraw at least the minimum amount his fund is required to pay 15 per cent tax on its taxable income ($6,300 less any franking credits). In addition, if Gareth wished to continue his account based pension in the next financial year, he would need to treat it as a new pension and start all over again.
If only Gareth had made a payment of at least 11/12th of what was required in total, then he would have been alright. If any underpayment was corrected as soon as it was discovered, the fund would have continued tax exempt and he wouldn’t have run into trouble. But as the underpayment was more than the Australian Taxation Office (ATO) concession, the pension is treated as having ceased for the year. Gareth has received a lump sum payment from the fund rather than a pension payment.
Because of what has happened, there are implications for Transfer Balance Cap (TBC) reporting. As the income stream is treated as ceasing on discovery of the underpayment then the balance of the pension will need to be reported to the ATO. Also, the treatment of the lump sum made in December 2018 will be reported for TBC as a commutation of the income stream. If Gareth decides to recommence the pension from 1 July in the next financial year the value of the account based pension will also be reported for TBC purposes. It would be interesting to see whether the ATO will impose penalties for any late TBC reporting.
Underpaying transition to retirement income streams
Since 1 July 2017 any income earned on investments to support transition to retirement income streams (TRIS) have been taxed at 15 per cent. However, once you meet a condition of release of retirement or you reach age 65, whichever is first, the income on those investments in the fund is tax exempt.
If you are drawing down a TRIS that is not in retirement phase any underpayment will result in amounts you receive being treated as a lump sum or series of lump sums. This can be treated by the ATO as a breach of the preservation standards because preserved amounts paid as lump sums are not permitted until you have retired or reached age 65, whichever is first. Any amount you receive may be taxed at personal rates irrespective of your age.
Because you have underpaid the TRIS, as a trustee of the fund you may be penalised by the ATO for breaching the pension standards.
If you receive a TRIS that is in retirement phase that has been underpaid, it is treated in a similar way to an underpaid account based pension. That is:
- Any income earned by the fund on investments supporting the pension is taxed at 15 per cent.
- Underpayments are treated as a series of lump sums paid to you.
- The lump sums are tax free if you are older than 60 or taxed on the taxable component of the amount received.
- The fund will need to report the stopping of the pension, the payment of the lump sum and any commencement of a new pension for TBC purposes.
- At the commencement of the next financial year the pension will need to start over again with new calculations and documents.
Underpaying reversionary and death benefit pensions
The SIS Act has specific rules about payment of death benefits from super. They allow all or part of a person’s death benefit to remain in the fund or rolled over to another fund only if the amount is used immediately to commence another income stream. It means that death benefits cannot be credited to a member’s accumulation account.
If the amount paid from a reversionary or death benefit account based income stream is less than the minimum required, it will cease. The fund will be faced with a limited number of options to ensure the income-stream balance remains within super. If the trustees don’t act as swiftly as possible it will require the balance is withdrawn from super altogether.
However, all is not lost as it is possible for the income-stream balance to remain in super providing the trustees get into action as soon as practicable. This can be done by:
- Converting the balance of the underpaid income stream to commence a new income stream in the same fund as soon as the trustees or the member becomes aware of the breach,
- Withdrawing the balance of the death benefit from the fund as a lump sum or as an interim and final lump sum,
- Rolling over the balance to another complying superannuation fund to immediately commence a new death benefit income stream.
These actions won’t fix the damage that has already been done by the underpayment, but the ATO accepts that the balance of the death benefit has remained continually in income stream phase. Trustees must act as soon as the underpayment of the reversionary or death benefit pension has been detected otherwise it may require the withdrawal of the whole of the balance of the death benefit pension as a lump sum. Just think of the issues that would cause.
The takeout from underpaying income streams is to make sure the minimum is paid as required. This is easy to arrange with an automatic transfer from the fund’s bank account or a quick check in May or early June each year to see whether an additional payment is required to meet the minimum payment.
Subscribe to 'SMSF News' below to receive the latest articles straight to your inboxGraeme Colley, Executive Manager, SMSF Technical and Private Wealth, SuperConcepts
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