If your SMSF pension does not meet the super rules for the financial year you could be in strife. It could mean the income on the fund’s pension investments is taxed rather than being tax exempt, and in the worst case, the amount you receive could be taxed at full personal rates.
Each type of pension has its own set of rules, so you need to know how the pension rules work in your SMSF or you could end up paying the price. Here I’ve covered account-based pensions and transition to retirement pensions (TRIS) which are the main types of pensions being paid from SMSFs.
If you have an account-based pension you need to take a minimum pension each financial year which is calculated on the account balance at commencement and at 1 July in future years. The minimum pension depends on your age when the calculation is made and there is no maximum limit to the amount you can receive. Any income earned by the superannuation fund on investments supporting your account-based pension is tax exempt if you meet the rules.
But what happens if you don’t meet the rules? Suppose you don’t pay even the minimum amount of your account-based pension. Your pension is treated as if it has stopped from the start of the financial year in which the underpayment occurred, any payments you receive are technically treated as a series of lump sums and the income on assets that were supporting the pension is taxed in the super fund at 15 per cent. In addition, your pension balance will be returned to the accumulation phase of your SMSF and may lead to estate planning tax issues if an adult child receives your death benefit.
Here’s an example of what could happen:
Bella, who is 67 is receiving an account-based pension from her SMSF, the Bella Donna Superannuation Fund. The balance of her account-based pension on 1 July 2018 was $1.2 million and she is required to receive a minimum pension equal to at least five per cent of that balance ($60,000) during the 2018/19 financial year. She draws $10,000 from her SMSF and the investments supporting the account-based pension earn $84,000 for the year.
As the pension is treated as ceasing on 1 July 2018 the pension balance will transfer to accumulation phase from that time and any income earned on the fund investments will be taxed at 15 per cent. From 1 July 2019, if Bella wishes to draw an account-based pension, she will have to draw an amount from accumulation phase and start all over again. This may mean starting the pension with different tax-free and taxable proportions that may have an impact if a death benefit is paid to an adult child as the taxable proportion will be taxed at 15 per cent plus Medicare.
Transition to retirement pensions
In contrast, if you have a TRIS you must draw a pension between a minimum and maximum amount which is calculated at commencement and 1 July each subsequent financial year. The income on investments that supports a TRIS is taxed in the fund at 15 per cent if you haven’t retired or reached age 65. But once you have met the retirement or age conditions, any income earned by your SMSF on the pension investments is tax exempt, just like an account-based pension.
What happens if you don’t meet the rules for payment of the TRIS? If you have not retired after reaching your preservation age (currently 57) or reached age 65, whichever is the later, then the TRIS will be treated as ceasing for the financial year and any pension payments treated as a series of lump sums. Since 1 July 2017 the income earned by the fund on investments supporting a TRIS has been taxed at 15 per cent. If the TRIS does not meet the rules, then any income earned by the fund on assets used to support it will continue to be taxed at 15 per cent. However, as the pension payments are treated as lump sums it will usually result in a breach of the preservation standards and any preserved components would be treated as fully taxable to you at personal tax rates. This is something to be avoided, especially if you are between ages 60 and 65 as any pension payments received from a TRIS that complies is tax exempt when you receive it.
Here’s an example of what could happen if there was an under or over-payment of a TRIS:
Ellie is 61 and a member of the Lollipop Superannuation Fund which pays her a TRIS. The balance of her TRIS on 1 July 2018 is $1 million, fully preserved component, which means that her minimum pension is $40,000 (four per cent of her TRIS balance) and the maximum pension would be limited to $100,000 (10 per cent of $1 million).
During the 2018/19 financial year Ellie receives $30,000 from her TRIS and the investments supporting her TRIS earn $70,000 for the year. The fund will be required to pay tax on the income earned on the TRIS investments at the rate of 15 per cent. This is the same tax as if the TRIS complied with the rules. However, the $30,000 she received from her SMSF will be included in her tax return and taxed at personal rates because it is treated as lump sums paid in breach of the preservation standard.
Australian Taxation Office concession for underpayments
Just because you have underpaid the mandatory minimum pension, all is not lost if the amount is less than one-twelfth of the minimum required to be paid. The Australian Taxation Office (ATO) accepts that if the minimum pension has not been paid and any underpayment was due to:
- a genuine mistake, or
- because of circumstances beyond the recipients’ control
the pension will be treated as complying with the rules providing a catch-up amount is paid by the fund as soon as possible after the underpayment has been discovered. The catch-up payment is to be treated as if it was made in the year in which the underpayment occurred.
The ATO’s concession applies only to underpayments of pensions and any pension overpayments of TRIS’ beyond the 10 per cent limit cannot be adjusted to allow it to comply with the pension standards.
Don’t think you can do the top-up every year as it applies only if it has not happened to the fund in the past. So it looks like it’s only available on a once-only basis.
Your transfer balance cap
Of course, every time you commence an account-based pension, or your TRIS falls into retirement phase it is counted against your $1.6 million transfer balance cap account. Any pension that has been counted and treated as ceasing will reduce the balance of your transfer balance cap account. This is because the transfer from pension phase to accumulation phase is treated as a commutation of the pension. If you commence a new pension that is in retirement phase it will increase the balance of your transfer balance cap account.
Where to now
The obvious warning is, ‘Don’t underpay your pensions otherwise there could be consequences’. So make sure you know how much pension has been paid from your SMSF, how much should have been paid and if there is a shortfall make a payment equal to the difference to avoid any issues.
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