Tax troubles with paying pensions from an SMSF

Paying less than the required minimum account-based income stream (pension) can mean a loss of the tax exemption for income earned on pension investments. But underpaying a reversionary or death benefit pension can be worse as you may lose the tax exemption and may need to withdraw the whole balance out of the fund. So don’t underestimate the consequences of underpaying pensions from your SMSF.

What’s the issue?

It is compulsory to pay benefits ‘as soon as practicable’ after a member’s death as a lump sum or a death benefit pension or as a combination. This will take place once the fund has worked out who is to receive the benefit and whether the fund has enough cash to pay the lump sum or pension. If the death benefit is cashed as a pension, transfer balance cap consequences may become an issue and where it is exceeded, the fund is required to pay a lump sum to the beneficiaries.

If the deceased member’s benefit is cashed as a death benefit pension, the cashing requirement is met where the pension continues to be paid. The issue is that if the amount of the death benefit pension is less than the minimum required it will not satisfy the pension standards from the start of the financial year. The upshot is that the pension no longer meets the cashing requirement for the death benefit and is in breach of pension standards.

Can it be fixed?

Because the pension failed to meet the pension standards, the only option available was to cash out the entire death benefit pension as a lump sum. This meant that the option to restart the pension at the start of the next income year which applied for account-based pensions would not be available. This requirement would create some challenges for funds with lumpy assets and in other situations capital was being forced out of a concessionally taxed environment.

The ATO managed to put forward a solution in July last year to death benefit pensions that were underpaid. This issue could be rectified by one of three possible options:

1. stop the death benefit pension and immediately commence a new retirement phase income stream as soon as the member or trustee is aware of the breach
2. cash the benefit as a lump sum (either as a single lump sum or as an interim and final lump sum)
3. roll over the death benefit income stream pension to commence another complying super fund and start a new death benefit income stream.

The ATO’s update can be accessed from their website by searching QC59673 or click here.

Questions raised from the ATO recommended options

With the super reform changes from 1 July 2017, a new rule was introduced so that “once a death benefit pension, always a death benefit pension”. This requires death benefit pensions to be identified independently of other retirement-based pensions to prevent them being mixed or transferred into a member’s accumulation balance in the fund.

The first option put forward by the ATO (above) refers to stopping the death benefit pension and starting a new retirement phase income stream. This may not be accurate as the law requires any death benefit pension to be commuted and used to commence a new death benefit pension or withdrawn from the fund as a lump sum. However, if it is correct and the death benefit pension in option 1 can be rolled over to commence a retirement phase income stream then a number of strategies are possible. One could be to roll the balance into the recipient’s accumulation balance.

Changes were made to the ATO publication that the solutions applied only to reversionary pensions. However, our view is that this should not impact on death benefit pensions when the minimum payment has not occurred. It is intended to apply to all death benefit pensions.

Treatment of tax components

The ATO’s solutions only address the issue of the compulsory cashing requirements. However, if the first option to commence a new retirement phase income stream is used to rectify the situation, clarification is required of how the proportioning rules work. The proportioning rules determine the taxable and tax-free components of the income stream which are relevant when any death benefit is subsequently taxed in the hands of an adult child.

The issue is whether the amount used to pay the death benefit pension retains its taxable and tax-free components on commencing the new income stream or be mixed with those components in the member’s accumulation account, if one exists. The effect can be to water down the tax-free proportion of the new income stream and can only be determined on a case by case basis.

Impact on Transfer Balance Cap

Failing to pay the minimum pension for the year means that any death benefit pension will no longer be in retirement phase. Because of this change, a Transfer Balance Account Report will be lodged with the ATO to debit the member’s account by the balance of the death benefit pension.

The main problem that arises is that the death benefit pension is deemed to have ceased as at 1 July at the start of the financial year in which the underpayment was made. However, you do not know that the pension has been underpaid until the financial year is finished on 30 June. This requires the fund to treat the death benefit pension as if it still existed for the whole of the financial year to work out the balance on 30 June when the Transfer Balance Account Report is required to be prepared.

Further guidance to clear this up

It would be useful in view of what the ATO has said to get some more guidance on how the Superannuation Industry (Supervision) Act and the tax law link for the underpayment of death benefit pensions especially around the taxable and tax free component calculation.

The lesson to be learned is that you won’t need to read articles like this and have sleepless nights if you pay the required minimum pension from your SMSF.