Are you making a mistake when commencing a pension with specific contributions?

Commencinga pension is one of the most important tasks to running a self-managed superfund (SMSF). An SMSF with a correctly established pension interest may beeligible to claim tax exempt income, a significant tax concession to the fund.However, there are some common mistakes trustees make when commencing a pensionusing 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 openingaccumulation balance of $150,000 from previous concessional contributions andincome. Between 1 July 2016 and 31 December 2016 the fund received $10,000 inconcessional contributions for each member. John also made a personalnon-concessional contribution of $180,000 on 4 January. On 9 January Johnretired and decided to convert $180,000 to an account-based pension and leavehis remaining balance in accumulation phase.

On 9 January John’s accumulation interest was the sum of:

  • $150,000 opening accumulation balance
  • $10,000 concessional contributions
  • $180,000 non-concessional contribution

John’sintention was to start his pension using only the $180,000 non-concessionalcontribution made to the fund on 4 January. The SMSF had received thecontribution and so John assumed he could complete trustee minutes to commencean account-based pension with $180,000 on 9 January and for that pension to bemade up of a 100% tax free component since the contribution wasnon-concessional.

However John’s assumption would be incorrect. There are two key additionalsteps John must consider:

  • fund assets must be revalued at market value 
  • the tax free and taxable components of the accumulation interest must be calculated.

Re-valuingfund assets in order to calculate the tax components

A member can have only one accumulation interest and any contribution to theSMSF will add to that accumulation interest. The tax free and taxable componentof this accumulation interest is always changing based on contributions andearnings received.

It does not matter if a member wishes to commence a pension using their fullaccumulation balance or only a specific proportion of their accumulationbalance, the accumulation interest must be re-valued in order to calculate thetax components. This is because the tax components of the new pension interestmust be the same as the tax components of the member’s accumulation interestjust before the commencement of the pension. Even if a pension is commenced onthe same date a contribution is received into the fund the tax components needto be re-calculated, unless the member had no existing accumulation balance atthat date.

The ATO state in their guide to starting and stopping a pension[1]:

Once a super income stream commences, you’rerequired to treat the amount supporting the income stream as a separateinterest in accordance with the income tax laws.

The value of the separate interest, including the amount of its tax free andtaxable components, must be determined when the super income stream commences.The proportions of the tax components of this separate interest, will be thesame as the proportions for the tax components of the member’s originalnon-pension interest just prior to the commencement of the income stream. Thisprevents members from choosing which tax components they wish to start a superincome stream with.

Information on re-valuation requirements can also be found in the ATO’sValuation guidelines for self-managed superannuation funds[2].

Case study revisited: calculating the taxcomponents of John’s pension

John cannot choose to set the tax components of his pension equal to the 100%tax free component of the non-concessional contribution. The tax components ofthe new pension must be based on the tax components of his total accumulationinterest just prior to commencement.

The market value of John’s accumulation balance as at 9 January was $342,000made up of:

  • $150,000 opening accumulation balance
  • $10,000 concessional contributions
  • $180,000 non-concessional contribution
  • $2,000 earnings

John’saccumulation interest prior to him making the non-concessional contribution wasmade up solely of concessional contributions and investment earnings. As suchhis accumulation interest had a $0 tax free component.

At 9 January after making the non-concessional contribution his tax freecomponent increased to $180,000. The tax free proportion of his accumulationinterest is therefore:

=  $180,000/$342,000

=  52.63% tax free component

When documenting the details of his new pension the tax free and taxablecomponents will be based on this proportion.

  • Commencement value $180,000
  • Tax free component 52.63%

Thetaxable component is therefore 47.37%. The tax free and the taxable componentsare fixed and will not change over the life of the pension. Any incomeallocated to the pension account will not affect the tax free proportion andpension payments made from this account will be made up of the same tax free andtaxable components.

Keeping track of tax components of pensions

Getting the tax components right is important when paying tax on payments underage 60, and if benefits are paid to non-dependants upon the death of thepensioner. This calculation is best done up front as part of setting the termsof 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 iscommenced. It is possible for a member to have multiple pension interests, eachwith different tax free and taxable components.

Impact of tax components on Accurium’s actuarial certificate applicationform

The revaluation of a member’s accumulation interest when a pension commencesalso provides the information needed to complete an application for anactuarial certificate. Recently we made changes to our certificate applicationform to ensure we can clearly identify when a member chooses to commence apension with only a proportion of their accumulation interest.

To show a pension commencement on our form you will be asked to enter thepension purchase price and also the amount remaining in the accumulationaccount after the pension commencement occurs. This is generally the marketvalue 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 apurchase 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 on1800 203 123.


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