A key matter of importance to SMSF trustees is correctly claiming exempt current pension income (ECPI) and, in particular, understanding how ECPI is calculated when the fund has segregated assets. A fund’s assets can be segregated in many different ways and for many different reasons.
Our experience has shown that most SMSFs that have both retirement and non-retirement phase member accounts use the proportionate method when claiming ECPI. However, an important issue that trustees need to be aware of when they are looking to implement segregation as part of their investment strategy is that segregated assets cannot exceed the value of the account balance.
We know that part of an asset cannot be segregated. This makes large indivisible assets, like property, difficult to segregate. Where a fund is looking to segregate an asset to a retirement phase income stream it must ensure that the market value of the asset does not exceed the account balance of the income stream.
At 1 July 2019 a fund had assets totalling $900,000. This was composed of a bank account with $50,000, $350,000 in shares and a property valued at $500,000.
At 1 July 2019 the fund had two members. Member One (M1) had an account balance of $125,000 in accumulation phase and had $275,000 supporting a transition to retirement income stream which was in retirement phase. Member Two (M2) had an accumulation account balance of $500,000.
On 1 July 2019 M2 decided to commence an account-based pension with their entire accumulation balance. The fund’s trustees are considering whether to segregate assets to support the retirement phase income streams in the fund.
Scenario 1 – proportionate
If the trustees do NOT segregate assets the fund’s assets will remain unsegregated as follows:
All of the fund’s assets are pooled to support each member’s account balances. The fund will require an actuarial certificate after 30 June 2020 to claim ECPI for the 2019/20 year.
Scenario 2 – partial (hybrid) segregation
If we consider that M2 wishes to segregate some fund assets to support their new retirement phase pension. Their retirement phase pension account balance at 1 July 2019 is $500,000, therefore the total value of the assets allocated to support the income stream cannot exceed $500,000.
The property held by the fund is valued at $500,000 at 1 July 2019. M2 decides to segregate this property to support their retirement phase pension of $500,000. They complete appropriate trustee minutes to reflect this decision and update the fund’s investment strategy to reflect the differing investment strategy of M1 and M2. This asset is now a segregated current pension asset. M2 also sets up a new separate bank account to receive any income from the segregated asset and to make pension payments.
The fund is now partially segregated. The fund will use the proportionate method to claim ECPI in relation to income earned on the pool of assets supporting M1’s retirement phase income stream and accumulation liabilities. Income earned on the property and bank account supporting M2’s retirement phase income stream will be entirely tax exempt using the segregated method.
The fund’s asset structure now looks like:
Assuming this segregation remains in place for 2019/20, the fund will use both the segregated and proportionate methods for claiming ECPI. However, this segregated scenario is potentially one of high risk to the fund.
M2 will be required to make an annual minimum pension payment of say $20,000. This payment must be made in form and effect from the member’s retirement phase income stream. As the value of segregated assets exactly equals the member’s retirement phase account balance, the pension payments must be made from this segregated pool of assets.
In this scenario; if the property does not earn at least $20,000 in net rental income (deposited into the segregated bank account) the member will not have sufficient liquid assets to make the pension payments and therefore will not meet the minimum pension standards.
If this eventuates, the retirement phase income steam will not be considered a pension for the financial year. Given that there would be no retirement phase liabilities for the asset to support, the property would no longer be classed as a segregated current pension asset and all assets would be unsegregated for ECPI purposes. Provided the pension standards are met on M1’s TRIS, the fund could still claim ECPI under the proportionate method, but only the M1’s TRIS would be counted as a retirement phase account when the actuary calculates the tax exempt proportion. .
Often in this scenario we see trustees making the required pension payments from the fund’s general bank account (which we can see is actually M1’s bank account) rather than the segregated bank account. This results in the value of the assets supporting the retirement phase income stream being greater than the account balance of the income stream.
To illustrate this – if pension payments were made on 1 July 2019 then the fund’s assets would be allocated as follows:
We can see that the segregated property and bank account exceed the value of the income stream. The asset is therefore not considered segregated and the fund would need to use the proportionate method for claiming all of its ECPI for the financial year.
Scenario 3 – full segregation
Finally, we consider the situation where the fund’s trustees decide to segregate assets to support all of its retirement phase accounts at 1 July 2019. They decide to allocate the $500,000 property, the $50,000 bank account and $225,000 of the shares (note that this should equate to an exact number of shares as we can’t segregate part of a share).
They complete appropriate trustee minutes to reflect this decision and update the fund’s investment strategy to reflect the differing investment strategy of the accumulation and retirement phase interests. The fund also sets up a new separate bank account to receive any income from the unsegregated shares, which are currently solely supporting accumulation, and to receive any future contributions.
The fund will claim ECPI using the segregated method and will not require an actuarial certificate. All income earned on the unsegregated shares and bank account which were supporting the accumulation interest will be taxable. Income earned on the property, shares and bank account segregated to retirement phase pension will be exempt income. Again, the members must draw their minimum pensions from the segregated retirement phase pension bank account to ensure they are eligible for the income tax exemption and to ensure the assets remain segregated.