An SMSF that allows reserves to be established should have a trustee and advisers who are on top of things to make sure they are used correctly. If reserves are used incorrectly, they may result in tax being paid on the amount transferred to a member’s super fund account.
What is a reserve in an SMSF?
A reserve is an account in a superannuation fund which is set aside for various purposes as permitted by the trust deed. The amount in the reserve does not belong to any member of the fund and can be used for a variety of purposes, including:
- The allocation of member contributions from one year to another may be used to help with tax and excess contribution issue. This is not technically a reserve but may act as a suspense account to allocate the contributions. We discuss this in more detail below.
- Pension reserves which is used to pay defined benefit pensions to members. These pensions have not been able to commence in an SMSF since 1 January 2005 but there is still a number of them still in existence
- Investment smoothing reserves which is used to average out long-term investment returns for members and are used mainly by larger super funds.
- Self-insurance reserves – monies set aside to provide insurance cover to members without the need for an insurance policy.
- General reserves – a reserve used to pay fund expenses.
Amounts held in reserves may be allocated to members over time. The amount can count towards a member’s concessional contribution cap, unless the allocation is done on a fair and reasonable basis for all members - and the amount allocated is less than 5% of the value of the member’s total balance in the fund. However, SMSF Ruling 2018/1 requires that the total amount must be allocated to the member’s accumulation account only.
In March 2018, the ATO released SMSF Regulator’s Bulletin 2018/1, the use of reserves by self-managed superannuation funds, which outlines their concerns about the potential misuse of reserves in SMSFs. The bulletin specifically addressed strategies potentially designed to circumvent legislative restrictions as a result of the recent super reforms.
The ATO is concerned about the intentional use of a reserve to artificially reduce a member’s total superannuation balance (TSB) as amounts allocated to a reserve do not form part of the member’s TSB. This may enable the member to make non-concessional contributions and access the bring forward rule without breaching the non-concessional cap or allow access to the catch-up concessional contribution arrangements.
Another concern is that SMSF trustees may use an existing reserve to circumvent the Transfer Balance Cap (TBC) rules. This could occur where the balance of a pension account is increased by an allocation from a reserve and the increase is not counted against the pensioner’s TBC.
The creation of new reserves, or unexplained increases or decreases in existing reserves, will be scrutinised by the ATO. The inappropriate use of reserves will potentially attract the anti-avoidance provisions and may result in tax penalties.
The main issue with reserves is how their size can be managed and how to deal with it when it is no longer needed, and avoid any adverse tax outcomes.
A common example is where the allocation of reserve monies may result in a significant tax bill after a complying lifetime or life expectancy pension has ceased. This can occur on the death of a member or when a life expectancy pension has reached the end of the set period. Normally, with these types of pensions, there is no member balance, instead a pool of monies is set aside in the fund to cover the pension payable to the member.
Any reserve amount left over after a lifetime or life expectancy pension ceases generally does not belong to the member. It won’t form part of the member’s death benefit and neither is it subject to a valid binding death benefit nomination.
- Alison is the sole trustee director and member of the Pink Parrot Super Fund. She has three adult children and who are the nominated beneficiaries upon her death. She has a lifetime complying pension which is non-reversionary. The fund assets of $1.5 million consist of Alison’s accumulation account of $500,000, and a reserve supporting Alison’s lifetime complying pension payments of $1 million. Alison passes away.
The reserve does not form part of Alison’s member balance and the standard reserve allocation principles apply.
Generally, allocations from reserves are not counted for concessional cap purposes if allocated in a fair and reasonable manner to every member, and the amount allocated for the financial year is less than 5% of the member’s interest in the fund.
If the full value of the reserve of $1 million is allocated to Alison’s member balance, so it can be paid out as part of the death benefit, the majority will be taxed as an excess concessional contribution at Alison’s marginal tax rate:
In addition, Alison’s adult children will most likely be required to pay 15% tax on any benefits received with a taxable component if paid via the estate, or 15% plus the Medicare levy where the death benefit is paid to the beneficiaries directly from the SMSF. This may not be considered to be the most optimal outcome from a tax point of view.
An alternative option would be for Alison’s children to become members of the fund so that the reserve can be incrementally allocated to them – a process which may take several years and would require the fund to be retained.
Another option, prior to Alison’s death, she may have been to transfer her entire lifetime complying pension to a market linked pension, as then which would avoid having to use solve the problem of what to do with the reserve after her death.
Reducing the value of a reserve
To avoid a large reserve being leftover in the event of the death of the member or cessation of a lifetime or life expectancy pension, it is important to properly manage the reserve.
- Jane (age 77) is the only member of the Tiger Super Fund. Her only income is her SMSF pension with a member balance of $680,000. The fund has a reserve with a balance of $100,000. Jane’s concessional cap is $25,000.
The following table illustrates the different tax outcomes when all of the reserve is allocated, versus just under 5% of the member’s interest.
It is worthwhile to monitor the reserve balance over time to ensure no adverse tax consequences arise where the pension ceases.
Commuting a defined benefit complying pension
When a defined benefit pension ceases, there is the possibility the fund will end up with a large reserve which may have significant tax consequences if allocated to members. There are a number of options available to manage the allocation.
This is especially crucial where the pension is about to cease, or the member’s personal circumstances indicate they are likely to pass away in the near future.
Options available to the client may include:
- Commuting the pension and transferring it to a retail complying annuity.
- Commuting the pension and commencing a market linked pension.
- Allowing the pension to cease and allocating funds from the fund reserve.
Using suspense accounts to allocate contributions
The Superannuation Industry (Supervision) Act allows contributions to be held in suspense account prior to allocation to a member’s account. The allocation must be made within 28 days after the end of the month in which they are made.
By using this provision it is possible to make concessional contributions up to a person’s concessional contributions cap to their accumulation account in the fund and have an amount held in a suspense account, which is allocated at the commencement of the next financial year within the time limits authorised by the SIS regulations.
The main benefit of this strategy is that a deduction can be claimed for the contribution in the year in which it is made and any amount credited to the suspense account in June of the financial year can be allocated to the member’s account by 28 July in the next financial year. For purposes of a person’s concessional contributions cap and Total Superannuation Balance amounts are not counted until the contributions are credited to the member’s accumulation account.
- Marty has made a good income in the 2019/20 financial year and would like to minimise the amount of tax he pays. He makes a concessional contribution of $50,000 in June 2020. The concessional contribution is taxed in the fund for the 2019/20 financial year. Marty decides to allocate $25,000 to his accumulation account and $25,000 is allocated to a suspense account. The amount allocated against Marty’s accumulation account in June 2020 is counted against his concessional contribution account. When the concessional contribution held in Marty’s suspense account is allocated to his accumulation account in July 2020, it will be counted against his concessional contributions cap for the 2020/21 financial year.
The benefit of this strategy is that a larger contribution can be made to the superannuation fund in a year when a person’s taxable income may be greater than usual, and the amounts will not be counted against the person’s concessional contributions cap or total super balance until they are allocated to the member’s account.
When used in combination with the bring forward concessional contributions rule that has operated since 1 July 2018, this can act as a useful tool in managing tax deductions for contributions and allocating amounts against a member’s accumulation account.
It may take a long time to deal with a reserve in an SMSF and the available options need to be considered. Failing to have a plan may result in significant adverse tax consequences.
The publications from the ATO see the use of reserves in larger regulated funds very differently from an SMSF. While they see the use of administration reserves, investment reserve and operational reserve appropriate for APRA-regulated funds, they do not, in the main, believe that such reserves should be part of an SMSF.
Consequently, SMSFs that use specific types of reserves are intended to be scrutinised by the ATO, particularly where the reserving strategy is used to reduce a member’s Total Super Balance to allow non-concessional contributions to the fund or skirt around the Transfer Balance Cap to increase a member’s pension account balance.
The use of suspense accounts to manage tax deduction and the allocation of amounts for purposes of concessional cap and total super balance cap purposes cannot be underestimated, especially in years when a windfall taxable gain or a person has earned income which is greater than they expected.
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