The superannuation reforms have increased the complexity of SMSF administration. The ATO’s view on segregated pension assets from 1 July 2017 further increases the administrative burden on self-managed super fund (SMSF) trustees and professionals.
The ATO view on segregated pension assets is that a fund whose assets are solely supporting retirement phase income streams at a time during the financial year must use the segregated method to claim exempt current pension income (ECPI) on income earned during that period. We call this a period of deemed segregation.
Common industry practice has been that funds would use the unsegregated method to claim ECPI over an entire income year where there were periods in a year where the fund had an accumulation interest. A fund would only have deemed segregation, and claim ECPI using the segregated method, if it was entirely in pension phase for the year. The ATO view on segregated pension assets applying from 1 July 2017 is likely to result in additional administration costs where funds have periods of deemed segregation and also unsegregated periods. The fund no longer has a choice to apply the administratively simple unsegregated method over the entire income year and instead may be required to track multiple accounting periods in order to claim ECPI in the annual tax return.
For periods of deemed segregation the segregated method must be used, and for periods where the fund has an accumulation interest the unsegregated method must be used.
On 1 July 2017 John was the sole member of an SMSF with $1.2million in pension phase and $200,000 in accumulation phase. On 1 August 2017 John made a non-concessional contribution of $100,000 and immediately commenced a new account-based pension using his entire accumulation balance of $305,000 at that date.
The SMSF continued entirely in retirement phase until John received a rollover on 1 January 2018 of $300,000. There is no intention for John to convert this rollover from accumulation phase to pension phase during the 2018 financial year.
The fund has a period in the year where assets are solely supporting retirement phase income streams, this could create a period of deemed segregation. Therefore the first new administrative requirement for the trustee is to determine whether the fund had disregarded small fund assets in 2017-18. This requires knowledge of the total superannuation balance of each member at 30 June 2017, and whether they had a retirement phase interest.
John had $1.2million in retirement phase at 30 June 2017 in the SMSF, and he has a balance in another fund in accumulation phase. The trustee needs to determine the value of that balance at 30 June 2017 in order to work out John’s total superannuation balance and check whether it exceeds $1.6million. If it does John actually cannot use the segregated method in 2017-18 due to having disregarded small fund assets. Let’s assume his total super balance at 30 June 2017 does not exceed $1.6million and so the fund does not have disregarded small fund assets.
The fund will be unable to use the unsegregated method for calculating ECPI over the entire financial year because over the period 1 August to 31 December assets are solely supporting retirement phase income streams. As such, the fund will have deemed segregation for this period. The fund is unsegregated over the period 1 July to 31 July and 1 January to 30 June, and an actuarial certificate will be required to claim ECPI on income earned in these periods.
The fund will claim ECPI using both the segregated and unsegregated method:
ECPI = income in segragetd pension assets between 1 August and 31 December
income on unsegragated assets x actuarial tax exempt percentage
In previous income years the fund may have utilised the unsegregated method over the entire income year. The ATO’s view on deemed segregation applying from 1 July 2017 now increases the work required to claim ECPI. This leads us to the second new administrative requirement, the fund needs to separate the income year into three accounting periods and work out the income and expenses incurred in each period in order to correctly claim ECPI and complete the SMSF annual return.
Avoiding the administrative cost of deemed segregation
One solution to avoid these additional administration requirements could be for the fund to maintain a very small accumulation account at all times in the financial year. In the case study above, if John chose to leave $10 in accumulation phase when he commenced pension on 1 August 2017 the fund’s assets would never be solely supporting retirement phase interests at any time during the year and would have no period of deemed segregation. The fund could use the unsegregated method to claim ECPI over the entire income year. An actuarial certificate would be obtained which considered all assets over the year, and the actuarial tax exempt percentage would apply to all eligible fund income. The fund would only need to maintain one accounting period and would not need to apply the disregarded small fund assets test.
Maintaining a very small accumulation balance at all times, until the trustees know that members will be solely in retirement phase over an entire income year, is one strategy that may be considered with a view to reducing the administrative cost of the ATO’s view on deemed segregation. This small balance is not likely to have a material impact on the actuarial tax exempt percentage calculation. In most instances the tax outcome for the fund will be similar whether the unsegregated method is used over the entire year, or both methods are used due to a deemed segregation period. Where the tax outcome can differ is if a fund receives large irregular capital gains, however which approach would provide for a better tax outcome depends on the timing of when the income was received.
Many funds are likely to have periods of deemed segregation in the 2017-18 due to not having time to plan in advance for the new ATO view. For example it is common to see members commence pensions on 1 July to maximise the pension balance for the year, and then later continue to receive contributions. These trustees face additional administration requirements and complexity in calculating ECPI and completing their annual return. In future years, the increased administration costs of running an SMSF with members who are in this pre-retirement phase may be avoided by thinking about whether it is appropriate for the fund to maintain a small accumulation balance until members fully retire in order to avoid creating periods of deemed segregation, or whether other options are available.