“There is no tax payable on income and capital gains on assets set aside to fund pension liabilities”
The ATO recently reported there are about 440,000 self-managed superannuation funds members (SMSF) receiving pension payments, and a further 250,000 SMSF members are expected to be receiving a pension within 10 years.
Pensions paid by super funds give rise to the biggest exemption being claimed by funds, as income and capital gains on assets set aside to fund pension liabilities is exempt from tax.
The pension exemption is a tax concession designed to encourage people to withdraw their super as a regular income stream rather than simply taking out a lump sum payment. The pension exemption is claimed in an SMSF’s tax return based on the assets that are set aside to fund that pension.
Traditionally people may have withdrawn a lump sum super benefit and had a great time spending it in their retirement. Afterwards they could become eligible for an old age (government) pension provided they qualified under the assets and income test.
So the government has provided an incentive, by way of the pension exemption, to encourage people to take a regular income stream so they hopefully preserve their retirement savings for their old age.
Despite this, the most popular pensions available today (both account-based and allocated pensions) allow the flexibility to withdraw a lump sum at any time. What retains the money in the super system is the attractiveness of the pension exemption, especially when a member turns 60. Pension payments paid to those over 60 are generally tax-free. Further, a fund paying a pension obtains an exemption for its pension assets.
A fund may claim the pension exemption based on a segregated or unsegregated method.
The segregated method relies on the fund selecting particular assets that are required to fund the pension. For example, if dad has $500,000 in his SMSF member account and starts a pension, it is the earnings (income and capital gains) on this $500,000 of assets that are covered by the exemption. The segregated method also requires the fund’s accounting system to keep track of, say, dividends and franking credits from the shares held within dad’s segregated portfolio to claim the exemption.
The alternative is for an SMSF to adopt the unsegregated method. This is where the SMSF is split evenly – say on a 50-50 account value basis. Let’s say there is $1 million in the fund earning 5 per cent a year. If dad starts a pension (and mum is still in accumulation phase), $25,000 of earnings is exempt on the assumption that dad’s pension interest is 50 per cent. So the fund is entitled to claim 50 per cent of the $50,000, producing $25,000 of exempt income.
The unsegregated method is more popular and generally easier to administer. Some advisers and administrators charge extra for the additional work involved with the segregated method.
There are also other pros and cons of adopting one method over the other, which can result in significantly different outcomes.
For example, under the segregated method both capital gains and capital losses on pension assets are totally disregarded. This can prove favourable where, say in the previous example, dad has a property that is segregated to his pension interest that has a $100,000 capital gain. By segregating this property, the capital gain is tax-free on sale. The ATO may, however, seek to apply the general anti-avoidance rule (Part IVA) if it considers the property is sold shortly after a pension starts and can seek to unwind any tax benefit.
On the other hand, the segregated method can result in the loss of a capital loss. Let’s look at what happens if dad’s pension assets include mining shares that realised a $100,000 capital loss on disposal. Under the segregated method, this $100,000 capital loss is lost forever. Note that the ATO considers an SMSF that is entirely in pension mode is segregated and will lose its capital losses. Such funds can establish an accumulation or reserve account to switch to the unsegregated method to preserve capital losses.
But if dad sold the property in the first financial year (and claimed a $100,000 exempt capital gain) under the segregated method, his fund could switch to the unsegregated method in a later financial year (for example when the mining shares are sold, to preserve the $100,000 capital loss). A capital loss can be carried forward under the unsegregated method and offset future capital gains.
If a fund adopts the unsegregated method, it’s required to obtain a certificate from an actuary each financial year confirming the percentage of the fund’s assets that finance the pension liabilities. While this adds an extra fee, this is generally much lower than the additional cost of managing a fund using the segregated method.
If a fund adopts the segregated method, there is no need to obtain an actuary’s certificate. The ATO recently confirmed this is the case even if a fund starts a pension part way through a financial year. Previously the ATO view suggested an actuarial certificate was required unless a fund was segregated for an entire financial year.
The ATO have also been ramping up its audit and review processes for funds claiming a pension exemption. As an example, if a fund has only 50 per cent of its assets deriving assessable income (with the other 50 per cent exempt under the pension exemption), it should generally claim 50 per cent of its expenses. So a fund in pension mode needs to pro-rata its expenses accordingly (as set out by the ATO in a tax ruling TR 93/17).
This article is for general information only and should not be relied upon without first seeking advice from an appropriately qualified professional.
Originally published as “How to claim the pension exemption”
http://www.afr.com/personal-finance/superannuation-and-smsfs/how-to-claim-the-pension-exemption-20151016-gkb832 by Daniel Butler in Financial Review on 18th October 2015
Daniel Butler is a director of DBA Lawyers and a leading SMSF lawyer.