Commencing a pension is one of the most important tasks to running a self-managed super fund (SMSF). An SMSF with a correctly established pension interest may be eligible to claim tax exempt income, a significant tax concession to the fund. However, there are some common mistakes trustees make when commencing a pension using only part of a member’s accumulation balance.
Case study: commencing a pension with a specific member contribution
John and Jenny have an SMSF. At 1 July 2016 both members had an opening accumulation balance of $150,000 from previous concessional contributions and income. Between 1 July 2016 and 31 December 2016 the fund received $10,000 in concessional contributions for each member. John also made a personal non-concessional contribution of $180,000 on 4 January. On 9 January John retired and decided to convert $180,000 to an account-based pension and leave his remaining balance in accumulation phase.
On 9 January John’s accumulation interest was the sum of:
John’s intention was to start his pension using only the $180,000 non-concessional contribution made to the fund on 4 January. The SMSF had received the contribution and so John assumed he could complete trustee minutes to commence an account-based pension with $180,000 on 9 January and for that pension to be made up of a 100% tax free component since the contribution was non-concessional.
However John’s assumption would be incorrect. There are two key additional steps John must consider:
Re-valuing fund assets in order to calculate the tax components
A member can have only one accumulation interest and any contribution to the SMSF will add to that accumulation interest. The tax free and taxable component of this accumulation interest is always changing based on contributions and earnings received.
It does not matter if a member wishes to commence a pension using their full accumulation balance or only a specific proportion of their accumulation balance, the accumulation interest must be re-valued in order to calculate the tax components. This is because the tax components of the new pension interest must be the same as the tax components of the member’s accumulation interest just before the commencement of the pension. Even if a pension is commenced on the same date a contribution is received into the fund the tax components need to be re-calculated, unless the member had no existing accumulation balance at that date.
The ATO state in their guide to starting and stopping a pension:
Once a super income stream commences, you're required to treat the amount supporting the income stream as a separate interest in accordance with the income tax laws.
The value of the separate interest, including the amount of its tax free and taxable components, must be determined when the super income stream commences. The proportions of the tax components of this separate interest, will be the same as the proportions for the tax components of the member’s original non-pension interest just prior to the commencement of the income stream. This prevents members from choosing which tax components they wish to start a super income stream with.
Information on re-valuation requirements can also be found in the ATO’s Valuation guidelines for self-managed superannuation funds.
John’s accumulation interest prior to him making the non-concessional contribution was made up solely of concessional contributions and investment earnings. As such his accumulation interest had a $0 tax free component.
At 9 January after making the non-concessional contribution his tax free component increased to $180,000. The tax free proportion of his accumulation interest is therefore:
= 52.63% tax free component
When documenting the details of his new pension the tax free and taxable components will be based on this proportion.
The taxable component is therefore 47.37%. The tax free and the taxable components are fixed and will not change over the life of the pension. Any income allocated to the pension account will not affect the tax free proportion and pension payments made from this account will be made up of the same tax free and taxable components.
Keeping track of tax components of pensions
Getting the tax components right is important when paying tax on payments under age 60, and if benefits are paid to non-dependants upon the death of the pensioner. This calculation is best done up front as part of setting the terms of the pension since it can be hard to work out many years down the track.
Calculation of the tax components must be done each time a new pension is commenced. It is possible for a member to have multiple pension interests, each with different tax free and taxable components.
Impact of tax components on Accurium’s actuarial certificate application form
The revaluation of a member’s accumulation interest when a pension commences also provides the information needed to complete an application for an actuarial certificate. Recently we made changes to our certificate application form to ensure we can clearly identify when a member chooses to commence a pension with only a proportion of their accumulation interest.
To show a pension commencement on our form you will be asked to enter the pension purchase price and also the amount remaining in the accumulation account after the pension commencement occurs. This is generally the market value of the accumulation interest less the purchase price of the pension.
For example, John would show a pension commencement as at 9 January 2017 with a purchase price of $180,000 and an amount remaining in accumulation of $162,000.
If you have any questions in regard to this article please give us a call on 1800 203 123.
The information in this document is provided by Accurium Pty Limited ABN 13 009 492 219 (Accurium). It is factual information only and is not intended to be financial product advice, tax advice or legal advice and should not be relied upon as such. The information is general in nature and may omit detail that could be significant to your particular circumstances. While all care has been taken to ensure the information is correct at the time of publishing, superannuation and tax legislation can change from time to time and Accurium is not liable for any loss arising from reliance on this information, including reliance on information that is no longer current. Tax is only one consideration when making a financial decision. We recommend that you seek appropriate professional advice before making any financial decisions.