Recontributions and other super interest(ing) pension strategies. Craig Day Executive Manager, FirstTech Colonial First State 97618: _4

Transcription

1 Recontributions Craig Day Executive Manager, FirstTech Colonial First State 97618: _4

2 CONTENTS Introduction... 3 Superannuation interests, proportioning and tax components... 3 Meaning of a superannuation interest... 3 Timing of valuation of superannuation interests... 4 Calculation of tax-free and taxable components... 5 Super interests and... 9 Starting a pension prior to making large non-concessional contributions... 9 Make excess non-concessional contributions prior to commencing a pension Targeting which benefits to rollover after negative returns Preservation of benefits Preservation and Start a hybrid TTR pension with both preserved and unrestricted non-preserved (UNP)... 18

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4 Disclaimer For adviser use only. Issued on 22 January 2015 by Colonial First State Investments Limited ABN , AFS Licence The subject matter of this paper is not advice and is information only. The information reflects Colonial First State s understanding of the relevant legislation and official government publications as at 22 January2015, and is based on its continuance for the entire income year unless stated otherwise. While every effort has been made to ensure that the information is accurate and reliable, this is not guaranteed in any way by Commonwealth Bank of Australia, Colonial First State or any other subsidiary. The information is not a substitute for clients seeking advice. Clients should direct enquiries in respect of their own particular circumstances to their financial adviser or tax accountant before acting on the information contained in this guide. Taxation considerations are general and based on present taxation laws and may be subject to change. You should seek independent, professional tax advice before making any decision based on this information. Colonial First State is also not a registered tax (financial) adviser under the Tax Agent Services Act 2009 and you should seek tax advice from a registered tax agent or a registered tax (financial) adviser if you intend to rely on this [information/advice] to satisfy the liabilities or obligations or claim entitlements that arise, or could arise, under a taxation law. 2

5 Introduction It is important to have a good understanding of the key taxation and superannuation concepts before commencing a pension in a Self-Managed Superannuation Fund (SMSF). These include the concepts of superannuation interests, tax components and proportioning and the preservation rules. A range of strategies can then be considered to optimise a client s retirement income stream arrangements once these concepts are fully understood. Superannuation interests, proportioning and tax components The concept of a superannuation interest applies to allow the calculation of the tax components of a superannuation benefit payment. Under the proportioning rules in section of the Income Tax Assessment Act 1997 (ITAA 97), the tax free and taxable components of a superannuation benefit are calculated by: 1. determining the proportions of tax-free and taxable component included in the value of the member s superannuation interest from which the benefit is being taken 2. Applying those proportions to the benefit being taken. Therefore, the tax components of a benefit payment will generally inherit the tax components of the superannuation interest from which it is drawn. For example, where a member took a benefit from a superannuation interest that was made up of 25% tax free component and 75% taxable component, the benefit payments would consist of 25% tax free component and 75% taxable component. Meaning of a superannuation interest Under regulation of the Income Tax Assessment Regulations 1997 (ITAR 97), a superannuation interest in an SMSF is defined as the combined value of every amount, benefit or entitlement that a member holds in the fund at that time. Therefore, under the proportioning rules, a member of an SMSF will generally only ever have one accumulation interest in an SMSF this applies regardless of the number of sub-accounts held for the member. However, an important exception to this rule is where a member has used part of their benefits in the fund to commence a superannuation income stream. In this case, reg confirms that the amount that supports that income stream is always to be treated as a separate superannuation interest. Therefore, where the member had satisfied a condition of release and used part of their accumulation balance to commence one or more income streams, they would have multiple super interests in the one fund. All of those interests must then be treated separately for the purposes of the proportioning rules. 3

6 Case study Kenny Kenny has an accumulation benefit in his SMSF as well as two different account based pensions commenced in the last five years. In this case Kenny would have three separate superannuation interests: Superannuation interest 1 (Accumulation) Superannuation interest 2 (Pension A) Superannuation interest 3 (Pension B) If Kenny then decided to commute a lump sum benefit from Pension A, the tax components of his other two interests would be ignored when calculating the tax components of the benefit payment. It is also important to note, while an amount that supports an income stream will always to be treated as a separate interest, this will not apply where a pension is commuted and the resulting lump sum is rolled back to form part of the member s accumulation benefits. In this case, the two amounts would merge and would no longer constitute separate interests. For example, if Kenny (from above) commuted Pension A and transferred the resulting lump sum back to the accumulation phase, the two separate interests would merge and become one interest. Timing of valuation of superannuation interests For the purpose of determining the tax components of a particular benefit payment, the value of the member s superannuation interest is determined at different times: where the benefit is a lump sum paid from an interest in the accumulation phase just before the benefit is paid where the benefit is a payment from a superannuation income stream (including a lump sum benefit paid from the commutation of the income stream) when the income stream commenced. Example 1 calculation of tax components of a benefit paid from an interest in the accumulation phase Just before taking a benefit of $10,000 from the accumulation phase, the components of a member s superannuation interest were calculated as follows: $60,000 tax-free $40,000 taxable 4

7 Therefore, as the member s interest was 60% tax-free and 40% taxable just before the benefit was received, the components of the lump sum payment would be calculated as $6,000 tax-free and $4,000 taxable. Example 2 calculation of the tax components of a benefit paid from an interest in a superannuation income stream A superannuation interest used to purchase an account-based pension on 1 July 2010 consisted of the following tax components just prior to commencement: $60,000 tax-free $40,000 taxable component. In this case, the tax components of the original interest would apply to the new pension, ie the pension interest would consist of 60% tax free component and 40% taxable component. In addition, the 60/40 component split would then apply to all future income and lump sum benefit payments paid from the pension. For example, if the member commuted $10,000 from the pension, the lump sum would be made up of $6,000 tax-free and $4,000 taxable. This applies regardless of the change in value of the pension over time. Calculation of tax-free and taxable components The tax free and the taxable components of a member s superannuation interest are calculated under section and section of the ITAA 97 as follows: Tax free component The tax-free component of a superannuation interest is calculated as follows: Contributions segment Contributions segment + Crystallised segment The contributions segment of a superannuation interest consists of the contributions made after 30 June 2007 to the extent that they have not been, and will not be, included in the assessable income of the superannuation provider. For example, these would include non concessional contributions, as well as non-assessable contributions that don t count towards the non-concessional contribution cap. These include: contributions that count towards the lifetime CGT cap contributions arising from structured settlements or orders for personal injury Government co-contributions. Note where a member has excess concessional contributions in a year, the amount of excess is included in the member s non-concessional contributions for the year under section ITAA 97. However, it is important to note that this does not mean that excess concessional contributions 5

8 count towards a member s tax free component. To the contrary, as the full amount of any employer or personal deductible contributions are included in a fund s assessable income under sections and respectively, they are excluded from the calculation of a member s contributions segment and therefore do not count towards tax free component. Crystallised segment The crystallised segment of a superannuation interest is the value of the following pre 1 July 2007 superannuation components as at 30 June 2007: undeducted contributions post June 1994 invalidity CGT exempt pre July 1983, and concessional. Where a member had any of these components the trustee was required to value those components as at 30 June 2007 and use that frozen figure when calculating the value of the member s tax free component. Taxable component The taxable component is simply the total value of the superannuation interest less the tax-free component. For example, if a member s superannuation interest was valued at $300,000, but the combined value of their contributions and crystallised segments was $200,000, their superannuation interest would be made up of a $200,000 tax free component and a $100,000 taxable component. Adjustment of tax components The value of the tax components of a member s superannuation interest will need to be adjusted in certain situations: Rollovers and withdrawals of the tax-free component Where a fund receives rollovers that include tax free component, or where tax free component has been included in a benefit payment, the trustee will need to adjust the amount of the member s tax free component accordingly. For example, where a member rolled over $200,000 that was 50% tax free component from one fund to another, the amount of tax free component in the original fund would need to be reduced by $100,000 and increased by $100,000 in the receiving fund. 6

9 Note a trustee receiving a rollover will calculate the member s tax free component in that fund based on the value of the member s contributions and crystallised segments in that fund plus the amount of the tax free component included in the rollover. This amount will be advised in the superannuation rollover benefit statement that is sent with the rollover. Allocation of insurance proceeds and anti-detriment amounts to pension interests Where a member who had commenced a pension dies, the existing tax component proportions that were set at commencement will continue to apply to the superannuation interest provided either: the pension is automatically reversionary a valid binding death nomination is in place which requires the trustee to continue to pay the death benefit as an income stream to a specified person. Therefore, any insurance proceeds allocated to the deceased member s pension interest prior to it reverting would form part of the taxable and tax-free components of the pension as per the tax component proportions calculated on commencement. For example, if a member commenced a pension that would revert to their spouse on their death with 100% tax-free component, 100% of any life insurance proceeds allocated to that pension interest would form part of the tax-free component. Alternatively, where the original pension did not automatically revert and no other amounts other than investment earnings, an amount paid under a life insurance policy or an anti-detriment payment have been added to the relevant super interest, the components of a death benefit paid as either a lump sum or income stream would be calculated under regulation of ITAR 97 as follows: Step 1: Reduce the amount of the total benefit (including any insurance proceeds or anti-detriment amounts) by any of the following: an anti-detriment increase an amount paid on or after the death of the deceased under a policy of insurance on the life of the deceased an amount arising on or after the death of the deceased from self-insurance. Step 2: Apply the original component proportions to the reduced amount to determine the tax free component of the benefit. Step 3: The taxable component of the benefit is the amount of the benefit less the tax free component of the benefit worked out under step 2 For example, if a member with an account based pension with a balance of $100,000 (90% tax free component) died, and their benefit was increased by $200,000 due to the allocation of proceeds of a life insurance policy, the components of any death benefit paid as a lump sum or income stream would be calculated as follows: 7

10 Step 1: Subtract insurance from value of benefit = $300,000 $200,000 = $100,000 Step 2: Apply original tax free % to determine tax free amount = $100,000 x 90% = $90,000 Step 3: Taxable component = benefit amount tax free = $300,000 $90,000 = $210,000 As a result, if the member s death benefit was used to commence an income stream payable to their spouse, the proportions of the new pension would be set at 30% tax free and 70% taxable. Modification for disability benefits Where a member has become permanently incapacitated and they are paid a lump sum disability superannuation benefit, the tax-free component of the benefit is increased to compensate the member for their lost future service. A disability superannuation benefit is: a lump sum benefit paid to a person (including a rollover to another superannuation fund 1 ) because he or she suffers from ill health (whether physical or mental), and two legally qualified medical practitioners have certified that, because of the ill health, it is unlikely that the person can ever be gainfully employed in a capacity for which he or she is reasonably qualified because of education, experience or training. The formula to calculate the tax-free component of a disability superannuation benefit is as follows 2 : Where: Existing tax free + [amount of benefit x Days to retirement Service days + Days to retirement ] Existing tax-free component = the sum of the tax-free component of the benefit worked out apart from using the disability formula Amount of benefit = the amount of the disability benefit being paid, including any insurance proceeds Days to retirement = the number of days from the day on which the person stopped being capable of being gainfully employed to their last retirement date (generally age 65) Service days = the number of days in the service period for the lump sum. 1 Excluding an amount used to commence a pension within the same fund. 2 Note: The tax-free component cannot exceed the amount of the benefit. 8

11 It is important to note that to modify the amount of the member s tax free component under this calculation they must actually receive a superannuation lump sum payment that qualifies as a disability superannuation benefit. Under section of the ITAA 97 a payment that is a rollover from one complying super fund to another is included in the definition of a superannuation lump sum benefit and will therefore trigger the calculation. However, it is important to note that an internal rollover to commence a pension within the same fund will not qualify. Therefore, if a member who qualified for a disability benefit wished to apply the formula prior to commencing a pension they would need to rollover their benefit from one fund to another. It should also be noted that under the calculation the longer the person s service and the closer they are to age 65 the smaller the smaller the uplift to the tax free component will be - until it effectively cuts out at age 65. Case study Sonya Sonya is a member of an SMSF and was recently diagnosed as being totally and permanently disabled due to illness. Her benefit details are: Service period five years Period to retirement 15 years Tax-free component $100,000 Taxable component $400,000 (including $200,000 TPD insurance proceeds). If Sonya were paid her whole balance as lump sum disability superannuation benefit, the tax components of her benefit would be calculated as follows: 5475 Tax free = $100,000 + [$500, ] = $475,000 Taxable = $500,000 $475,000 = $25,000 Alternatively, if Sonya had rolled over her disability benefit to another fund prior to commencing a pension, the pension payments would consist of 95% tax free component. Super interests and Understanding these rules can allow members to implement strategies to ensure they get the full benefit of the different tax concessions available. These strategies are now discussed in more detail. Starting a pension prior to making large non-concessional contributions Where a client with a benefit made up of 100% taxable component has met a condition of release and they wish to make a large non-concessional contribution (maybe with the proceeds of an 9

12 inheritance or as part of a recontrbution strategy), they should consider starting an account based pension with their existing taxable benefit first prior to making their non-concessional contribution. This strategy would allow the member to keep the taxable and tax free components separate by segregating the taxable component into a separate superannuation interest. The benefit of this strategy is that it allows the member to choose whether to take benefits from their taxable or tax free interest in isolation rather than having to take a benefit that is made up of both tax free and taxable components in accordance with the proportioning rules. Depending on the member s circumstances this could then provide the following advantages: for members between preservation age and age 60 segregating a members taxable and tax free components into separate pension interests could allow these members to draw lump sums (subject to preservation rules) from the pension made up of 100% taxable component as these amounts would count towards the minimum pension requirement and be tax free up to the low rate threshold 3 Alternatively, the member could draw any additional pension payments (ie amounts above the minimum) from the pension made up of 100% tax free component in isolation. This would ensure the pension payments would be 100% tax free (assuming the member is aged below 60). For members age 60 or over while lump sum and pension payments are tax free from age 60, segregating tax components into separate superannuation interests may still provide tax benefits in the event that the member dies and part of their benefit ends up being paid to a non-death benefits dependant, such as an adult child. In this case, by segregating the tax free component into a separate pension it allows the trustee to pay any lump sum death benefit payments to non-death benefits dependants from the 100% tax free pension. This ensures those amounts would be 100% tax free and would not be subject to death benefits tax of 17%. Case study Bert Bert retired in early 2014 at age 62 with a super balance of $1,080,000 (100% taxable). Bert immediately withdrew a $540,000 lump sum benefit and then commenced an account based pension with his remaining super balance ($540, % taxable component). At the time of commencing the pension Bert nominated his second spouse, Patricia, as his reversionary beneficiary. Bert then recontributed the $540,000 lump sum as a non-concessional contribution and used it to commence a 100% tax free account based pension. Bert then put in place a binding death benefit nomination requiring the trustee to pay any death benefits from his second pension to his adult financially independent children from his first marriage. 3 Low rate threshold currently $185,000 for

13 If Bert then died in 2015, the whole amount of his death benefit paid to his adult children would be tax free as the lump sum death benefit payments would consist of 100% tax free component. Alternatively, had Bert recontributed the $540,000 prior to commencing the two separate pensions, the total death benefit tax payable would be: tax components of both pensions based on proportions at commencement: o tax free component 50% tax free o taxable component 50% taxable tax payable on lump sum death benefits paid to adult children (assuming current account balance matches original purchase price): o tax on 50% taxable component: $270,000 x 17% = $45,900 o tax on 50% tax free component = Nil Therefore, by using a recontribution strategy to commence two separate pensions, Bert has been able to arrange his estate planning situation to maximise any potential death benefits to be paid to his non-death benefits dependant beneficiaries. Practical issues To implement this strategy trustees should ensure the pension is commenced before the nonconcessional contribution being made. As per Tax Ruling 2013/5 a pension cannot have commenced until: the member has made an application to the trustee to commence a pension the member and the trustee have agreed to the terms and conditions under which the pension will be paid, and all the capital which is to support the pension has been paid to the fund by way of contribution or rollover. Depending on the time it takes to properly establish a pension in an SMSF, a member may need to hold off from making the contribution for some weeks or months. Alternatively, the member could delay cashing out the lump sum until the trustee is ready to commence a pension. Once this is arranged the member could cash out the lump sum on day one, commence the first pension on day two and then recontribute the lump sum and commence the second pension on day three. This would have the advantage of minimising the time the lump sum is required to remain outside the super environment. Members age 65 or over should also ensure they are eligible to contribute under the work test and that the contribution would not cause the member to exceed their non-concessional contributions cap. (For members aged 65 or over the non-concessional cap amount reduces to $180,000 maximum). Members under age 60 should also be aware that amounts of taxable component withdrawn under the recontribution strategy is only tax free up to the low rate cap of $185,000. Therefore they may need to take into account any tax payable on a lump sum withdrawal.. It is also important to note 11

14 that amounts within the low rate cap are still included in assessable income (an offset applies to reduce tax to zero) and therefore may impact the member s entitlement to any income tested benefits or concessions. Where trustees will need to dispose of CGT assets to facilitate a recontribution strategy, the member should ensure they also factor in any CGT liabilities when considering the benefits of the strategy. Make excess non-concessional contributions prior to commencing a pension Under Tax and Superannuation Laws Amendment (2014 Measures No. 7) Bill 2014, it is proposed that members who have exceeded their non-concessional contributions cap will be able to have their excess contributions (plus 85% of any deemed earnings) released from super without being subject to excess contributions tax. In this case, an amount of deemed earnings 4 on those excess contributions will be included in the member s assessable income with a 15% offset available to offset the tax paid in the fund on the actual earnings. Importantly, while under the proposed rules the amount of the excess contributions to be released under a release authority will be treated as a superannuation benefit payment, the explanatory memorandum to the bill confirms that the proportioning rules will not apply to the amounts released. In this case, it appears the amount of excess non-concessional contributions released would not specifically be required to be deducted from the member s tax free component. As a result, while the amount of excess non-concessional contribution will increase the member s tax free component, the amount released would effectively result in a reduction of their taxable component. In this case, if implemented in their current form, the release of a large amount of excess nonconcessional contribution could effectively result in the conversion of some or all of a member s taxable component into tax free component. Case study Vera Vera turned 55 on 1 May 2014 and has existing super savings of $550,000 which comprise 100% taxable component. On 1 July 2014 Vera contributed $1,108,274 5 from the proceeds of the sale of an investment property to her SMSF as a non-concessional contribution. As a result, Vera is issued with an excess non-concessional contribution assessment of $568,274 for the year on 1 November The deemed earnings amount is proposed to be calculated at the average general interest charge (GIC) which was 9.66% for the 2014 year. The deemed earnings amount is to be calculated from the 1 July of the financial year in which the excess contribution is made and ends on the day that the Commissioner first makes his determination. 5 Note the fund capped contribution rules would require Vera to contribute the amount via several contributions, ie one contribution for $540,000 under the bring forward rules and then the balance as a separate contribution. 12

15 In accordance with the proposed rules, Vera s deemed earnings on the excess contributions would be calculated as $78,501 6 and she could then apply to have the $568,274 excess contributions plus $66,726 (85% of a deemed earnings amount) released back to her 7. In this case, assuming the fund s assets increased due to investment returns by $85,000 (after tax), her super balance immediately after the release would be calculated as follows: Super balance = ($550,000 + $1,108,274 + $85,000 8 ) ($568,274 + $66,726) = $1,108,274 The tax components of Vera s super interest would then be calculated as per the proportioning rules as follows: Tax free = $1,108,274 (based on value of NCC included in Vera s contribution segment) Taxable component = Nil (value of super interest less tax free component) In this case, because Vera s non-concessional contribution increased her tax free component but the amount released was paid from her taxable component, it effectively resulted in her benefit becoming 100% tax-free. If Vera then immediately commenced a TTR pension with all of her benefit, the pension would consist of 100% tax free component as per the proportioning rules. In this case, as Vera s pension payments would be completely tax free this would allow her to maximise the benefits of a TTR salary sacrifice strategy as it would allow her to maximise the amount she was able to salary sacrifice. However, it is important to remember that the refund of the excess non-concessional contributions would cause Vera s income to increase by $78,501. Assuming she was on the top marginal tax rate of 47% 9 this would result in an additional tax liability of $25,120 after taking into account the 15% rebate available on the amount of deemed income. However, it is important to remember that Vera would likely have generated some level of income in her own name anyway had she only made nonconcessional contributions up to the value of the non-concessional cap and invested the balance in income producing assets. Risks and disadvantages It is important to note that at the time of writing the amending bill to allow for the release of excess non-concessional contributions had yet to become law. Therefore, it will be important to confirm the proposed rules were implemented without any changes prior to proceeding. 6 Assuming general interest charge rate of 9.66% per annum (based on average of interest charge rate for the four quarters of ) or a daily rate of Note deemed earnings would be same regardless of date of contributions as calculation applies from first day of financial year in which contribution made. 8 Assumes a net pre-tax rate of return of 4.523%p.a.consisting of 100% income taxed at 15% 9 Including 2% Medicare but excluding the 2% Temporary Budget Repair Levy for income earned over $180,

16 Should the changes become law it will also be important to consider the potential application of the anti-tax avoidance measures in Part IVA of the Income Tax Assessment Act 1936 to this strategy. While the ATO has confirmed that the recontribution strategy, which results in a similar outcome of reducing taxable component, is not considered tax avoidance, it is not yet known how it would view this strategy. Members should therefore seek specialist tax advice before proceeding. If the strategy is to be recommended is critical to note that the member must make an election to release the excess amount (plus 85% of the deemed earnings) within 60 days of the date on the excess non-concessional contributions determination. Under the proposed rules the election must be provided to the ATO and be on an approved form. If the member fails to make an election within the allowable time the ATO will then issue the member an excess non-concessional contributions tax assessment. Finally, if the rules do become law, it will be important to note that the cashing rules in regulation 6.22A of the Superannuation Industry (Supervision) Regulations 1993 (SISR 93) may apply to require the amount to be deducted from the member s preservation component in the following order 10 : unrestricted non-preserved restricted non-preserved preserved. Therefore, depending on a member s circumstances, releasing an amount of excess nonconcessional contributions could result in a reduction of the member s unrestricted benefits. Targeting which benefits to rollover after negative returns Where a member wishes to consolidate multiple super accounts before commencing an income stream, it will be important to consider the tax components of each benefit. This is particularly relevant where any of the accounts have been impacted by negative investment returns as, depending on which benefit is rolled over, it could make a significant difference to the tax proportions of the final pension. Impact of negative returns on tax components Under the proportioning rules, the investment returns (either positive or negative) on a member s benefit will generally be applied to the value of a member s taxable component first. This happens by default as the taxable component is simply calculated as what s left over after the tax free component has been deducted from the account balance. However, where negative returns have decreased the value of the member s balance to an amount less than the combined value of the member s contributions and crystallised segments (ie the value of the tax free component), the 10 Note whether reg 6.22A to specify a cashing order will depend on whether the condition of release for these amounts will have a cashing restriction other than nil. At the time of writing the proposed conditions of release for excess non-concessional contributions had yet to be released. However, assuming cashing restrictions similar to those for compulsory and voluntary release authorities apply, the reg 6.22A would apply. 14

17 negative returns will effectively start reducing the member s tax free component as the value of the tax free component cannot exceed the value of the member s benefit. Impact of rollovers on tax components As a rollover is included in the definition of a superannuation benefit, the trustee of a fund rolling over a benefit will be required to determine the value of any tax free components included in a rollover as per the proportioning rules. The trustee will then be required to deduct that amount from the value of the member s contributions and crystallised segments when calculating the components of any benefits remaining in that fund. Conversely, the trustee of the receiving fund will be required to add the tax free amount rolled over to the member s contributions and crystallised segments to calculate the member s tax free component in that fund. Therefore, rolling over a tax free amount that has been reduced by negative returns will have the impact of locking in the reduced tax free amount. To illustrate how this can occur let s look at an example: Case study - Meg Meg is age 56 and has her retirement savings invested in two different superannuation funds, Fund A and Fund B. Fund A is an SMSF that was established on 1 July 2014 to accept a $1.04m ($500,000 CGT exempt / $540,000 non-concessional) contribution for Meg. Fund B is a large APRA regulated fund that she became a member of 20 years ago in order to make personal deductible contributions. As Meg has reached her preservation age she would like to consolidate her different superannuation interests into one fund and commence an account based TTR pension. As at 1 June 2014 Meg s super account balance details were: Fund A SMSF Total super interest Tax free component Taxable component $1.04m $1.04m (based on value of contributions segment) Nil Fund B APRA fund Total super interest $400,000 Tax free component Taxable component Nil $400,000 (based on value of total super interest less tax free) 15

18 However, due to some significant market volatility and lack of diversification of the assets acquired in the SMSF, the value of Meg s super interest in her SMSF has reduced to $840,000 over the past 6 months. In contrast, the value of Meg s interest in the APRA regulated fund has remained stable due to being invested in a diversified investment option. Meg s current super balances as at February 2015 are therefore as follows: Fund A SMSF Total super interest $840,000 Tax free component Taxable component $840,000 (value of contributions segment and crystallised segment notionally $1.04m however the value of tax free component cannot exceed value of super interest) Nil Fund B APRA fund Total super interest $400,000 Tax free component Taxable component Nil $400,000 (based on value of total super interest less tax free) In this situation, negative investment returns have reduced Meg s tax free component to $840,000, as her tax free component cannot exceed the value of her superannuation interest in the fund. If Meg then decided that an SMSF wasn t for her and rolled over her benefits in Fund A to Fund B, she would effectively lock in the value of her tax free component at $840,000. That is, the trustee of Fund B would calculate the amount of Meg s tax free based on the amount of tax free component included in the rollover rather than on the amount of Meg s CGT exempt and non-concessional contributions. As a result, the components of Fund B after receiving the rollover would be: Fund B APRA fund Total super interest $1.24m 16

19 Tax free component $840,000 Taxable component $400,000 (based on value of total super interest less tax free) Therefore, by rolling over the fund that contained her tax free component (Fund A) Meg will have locked in her tax free component value at $840,000, effectively reducing her tax free component by $200,000. If Meg then commenced a TTR pension, her pension tax components would be fixed at 68% tax free and 32% taxable. However, if Meg instead rolled over her whole interest in Fund B to Fund A she would get quite a different tax result. This is because Meg s balance would increase to $1.24m and therefore the level of Meg s tax free component would increase back up to $1.04m (based on the value of the CGT exempt and non-concessional contributions included in the contributions segment). Her taxable component would then be calculated as the balance. Fund A SMSF Total super interest Tax free component $1.24m $1.04m (based on value of NCC and CGT exempt contributions) Taxable component $200,000 Therefore, by rolling Fund B into Fund A, Meg has effectively converted $200,000 of taxable component into tax free component. If Meg then commenced a TTR pension, her pension tax components would be set at 84% tax free and 16% taxable instead of 68% tax free and 32% taxable. Preservation of benefits Under the superannuation preservation rules, a member can access their unrestricted nonpreserved benefits (UNP) at any time without restriction. However, where a member has preserved and restricted non-preserved benefits they will only be permitted to access them where they have satisfied a condition of release. Depending on which condition is satisfied, cashing restrictions may then apply to limit the form or amount of the benefit payment. For example, where a member has satisfied the condition of release of reaching their preservation age but they are yet to retire, they can only access their preserved benefits in the form of a noncommutable pension, such as a TTR pension. Where a member s interest is made up of both UNP and preserved benefits and they wish to start taking their benefit in the form of an income stream they can elect to either commence one hybrid 17

20 TTR pension that includes both preservation components or they can commence two separate pensions with the different components. For example, where a member had a superannuation benefit of $300,000, of which $200,000 was preserved and $100,000 UNP, they could elect to start one hybrid TTR pension with the whole $300,000 or use the $200,000 preserved component to commence a TTR pension and use the other $100,000 UNP component to commence an account based pension. Traditionally many advisers with clients in this situation have recommended clients establish two separate pensions. This was done to ensure the member would retain access to the full account balance, including any investment returns, on the account based pension, whereas any investment returns on a TTR (even where partly commenced with UNP component) will be fully preserved until the member satisfies a conditional of release with a nil cash restriction, ie retirement or turning age 65. Alternatively, a member with both preserved and UNP components could commence a hybrid transition to retirement pension. In this situation, regulation 6.22A of the Superannuation Industry (Supervision) Regulations 1997 (ITAR 97) will apply to require the trustee to deduct the income payments from the different preservation components in the following order: 1. unrestricted non-preserved 2. restricted non-preserved 3. preserved For example, where a 56 year old member commenced a TTR pension with $200,000, which was made up of $100,000 preserved and $100,000 of UNP, the trustee would be required to deduct the pension payments from the UNP component first and could only start deducting the payments from preserved component once UNP had been exhausted. Note the ATO has confirmed that the cashing order specified in 6.22A only applies to benefits cashed (or paid) from the fund and does not apply to the actual commencement of a pension, as that does not constitute a cashing event. This means that a member with both preserved and UNP components could elect to use just their preserved components to commence a TTR pension. 11 Preservation and Start a hybrid TTR pension with both preserved and unrestricted non-preserved (UNP) As previously discussed, where a member commencing a TTR pension has a mixture of unrestricted non-preserved and preserved benefits, the traditional wisdom has been to commence two income 11 National Tax Liaison Group: super technical sub-group minutes June

21 streams an account based pension consisting of UNP benefits and a TTR pension consisting only of preserved benefits. However, in 2014 the ATO released SMSFD 2014/1 which confirmed that partial commutations will count towards the annual pension minimum. As a result, members aged between preservation age and age 59 with even a relatively small level of UNP benefits may benefit from commencing one single TTR pension with a mixture of UNP and preserved benefits. This situation arises as by using at least some UNP component to commence a TTR, a member will be able to elect to take their minimum pension payments in the form of partial commutations (deducted from the UNP component) which they can elect to be taxed as lump sums In this case, the tax-effectiveness of a TTR strategy may increase dramatically as the payments can be received as tax free lump sums (any taxable component is tax free if within the low rate cap) rather than the taxable component of pension payments being taxed as assessable income with a 15% tax offset. Case study Ivan Ivan has just reached preservation age and has a balance of $300,000 in his SMSF, consisting of $60,000 UNP component and $240,000 preserved component. From a tax component perspective, his balance consists of 25% tax free component and 75% taxable component. He works full time earning a salary of $100,000. He wishes to undertake a TTR and salary sacrifice strategy to maximise his super balance in the lead up to retirement at age 60. Let s compare three options: 1. commencing a $300,000 TTR pension and receiving regular minimum pension payments of 4% each year 2. commencing a $240,000 TTR pension (electing to receive regular minimum pension payments of 4% each year), and an account based pension of $60,000 (electing take 4% minimum as lump sums) 3. commencing a $300,000 hybrid TTR pension and electing take the 4% minimum as lump sums. In all options, Ivan will salary sacrifice enough income to leave his net income unchanged at $73,053. Outcome at retirement Here is a comparison of total super balance at age 60 under all three options: No TTR strategy Option 1 Option 2 Option 3 12 Note reg 6.22A of SISR 93 requires the partial commutations to be deducted from UNP. 13 Note for a partial commutation to be taxed as a lump sum the member must, before the payment is made, make an election in accordance with paragraph (b) of the ITAR 1997 that the payment is not to be taxed as an income stream payment. 19

22 Single TTR with payments taxed as pension payments TTR plus ABP 4% minimum from ABP taken as lump sum Single TTR 4% minimum taken as lump sum Total super balance at age 60 Benefit of TTR strategy $447,587 $476,838 $481,775 $494,274 $29,250 $34,188 $46,687 Assumptions: rates and thresholds apply. No allowance has been made for inflation or wage increases. Super balances earn 7% income, all taxable at 15% in accumulation phase. Contributions and pension payments are assumed to occur half way through each financial year. Forecast is over a five year period. We can see that while a basic TTR strategy yields a benefit of close to $30,000 over the five year period, Ivan clearly benefits further under Options 2 and 3. This is because at least part of the total pension payments he receives are partial commutations treated as lump sums for tax purposes tax free within his low rate cap. By saving tax, Ivan can increase his level of salary sacrifice contributions each year, leading to a larger overall super benefit at retirement. Option 2 allows Ivan to take the minimum payments from one of his pensions as lump sums which allows him to add a further $4,937 in total super balance at retirement. However, under this scenario, he is still required to draw pension payments from his preserved TTR pension, which are taxed at his marginal rate less a 15% offset. Under Option 3, Ivan is able to elect to have virtually all his required minimum pension payments (except a small amount in year five when unrestricted non-preserved runs out) taxed as lump sums. This means that unlike Option 2, he is able to effectively receive the calculated minimum payment in respect of both his UNP and preserved benefits as tax free lump sums rather than pension payments. By making his TTR payments almost all tax free, he is able to further increase his salary sacrifice contributions while receiving the same level of net income, and additional super benefits of $12,499 accrue compared to Option 2. Considerations when implementing this strategy While the TTR partial commutation strategy has the potential to increase super balances for clients transitioning to retirement, the following should also be considered: Where a client or their partner is receiving a means tested social security benefit, any partial commutation of a TTR pension will permanently reduce the Centrelink/ DVA deductible amount of the pension under the income test. Note: deeming for income test purposes 20

23 applies to TTR pensions commenced from 1 January 2015 unless grandfathering provisions apply. While the taxable component of any partial commutation is tax-free up to the low rate cap between preservation age and 59, it is still included in assessable income and therefore may impact eligibility for income tested Government benefits and concessions. Tax Ruling TR 2013/5 states that a partial commutation will be considered an income stream payment for tax purposes unless the client has made an election for it to instead be a lump sum for tax purposes. When implementing this strategy it is important to ensure that this election is made prior to the partial commutation. 21

24 Disclaimer For adviser use only. Issued on 22 January 2015 by Colonial First State Investments Limited ABN , AFS Licence The subject matter of this paper is not advice and is information only. The information reflects Colonial First State s understanding of the relevant legislation and official government publications as at 22 January2015, and is based on its continuance for the entire income year unless stated otherwise. While every effort has been made to ensure that the information is accurate and reliable, this is not guaranteed in any way by Commonwealth Bank of Australia, Colonial First State or any other subsidiary. The information is not a substitute for clients seeking advice. Clients should direct enquiries in respect of their own particular circumstances to their financial adviser or tax accountant before acting on the information contained in this guide. Taxation considerations are general and based on present taxation laws and may be subject to change. You should seek independent, professional tax advice before making any decision based on this information. Colonial First State is also not a registered tax (financial) adviser under the Tax Agent Services Act 2009 and you should seek tax advice from a registered tax agent or a registered tax (financial) adviser if you intend to rely on this [information/advice] to satisfy the liabilities or obligations or claim entitlements that arise, or could arise, under a taxation law. 22