Fund freedom: PREPs offer taxpayers a retirement alternative

Very soon taxpayers will have the choice to access all or part of their superannuation savings. They will have this choice without having to retire. The pre-condition is that they have to have reached their preservation age.

A taxpayer could wind down their working week from five days to four (or even three) and fill the resulting gap in their income by accessing their superannuation savings. Alternatively, a taxpayer could move to a less demanding role with a lower salary and access their superannuation savings to fill the resulting gap in income. A taxpayer could make a short term sea change by accessing their superannuation savings.

Seems too good to be true? Seems contrary to the ever tightening march of preservation? Welcome to the world of pre-retirement income streams (PREPS), and that world commenced on July 1.

The potential uses of PREPs will be considerable. There is no requirement that the taxpayer must in fact reduce their working hours or restructure their position or work functions to a less demanding role before a PREP can be commenced. The Government considered, but ultimately rejected imposing any such limits.

Further, commencing a PREP does not preclude a taxpayer from making personal superannuation contributions or receiving employer superannuation support. In fact, the superannuation fund paying the PREP could be the same fund to which contributions are being made by or on behalf of the taxpayer. In this situation the fund will simply run two member accounts — one for the PREP and the other for the contributions.

Obviously, PREPs could be used to fill the income gap when a taxpayer transitions from full time to part time work. However, they have other advantages.

Commencing a PREP will bring forward the time at which superannuation savings are reasonable benefit limit (RBL) tested. There may be advantages for a taxpayer to bring forward RBL testing of part of their benefit.

Commencing an allocated PREP with a drawdown using the minimum pension factor will, for a given level of pension drawdown, place a greater portion of the taxpayer’s superannuation savings on the “pension side” rather than the “growth side” of the fund.

Where the taxpayer is able to utilise the small business retirement exemption under capital gains tax, the capital gain can be paid as a superannuation contribution. The taxpayer could then commence a PREP with an undeducted purchase price consisting of the resulting capital gains tax (CGT) exempt component.

Also, after a PREP has commenced, assets with unrealised capital gains could be segregated to support the payment of the pension and realised in accordance with the investment strategy of the PREP.

PREPs have their origin in a statement made by Treasurer Peter Costello’s on 25 February, 2004. They are intended to increase flexibility for taxpayers in the period between preservation age and attaining age, accommodate changing work patterns and reduce incentives for taxpayers to exit the workforce simply to access their superannuation savings.

Essentially, PREPs are non-commutable versions of the Superannuation Industry (Supervision) Act 1993 (SIS) income streams — whether superannuation pensions or eligible termination payment annuities. However there is no PREP version of commutable defined benefit pensions (and their ETP annuity equivalents). To qualify as a PREP, the income stream must still satisfy all the requirements that apply to the particular type of income stream, and must not be commutable from its commencement to age 65 (or earlier satisfaction of an unrestricted release condition). Exceptions to this non-commutation before age 65 are permitted to pay superannuation surcharge debts to effect payment splits, and to cash an unrestricted benefits.

Allocated PREPs will generally be the most appealing to taxpayers — these are simply allocated pensions or annuities that comply with the commutation restrictions in the period from commencement to age 65. Allocated PREPs have the greatest flexibility of all PREPs during the non-commutation period because:

* they can be stopped (in part or entirely); and

* the drawdown amounts can be varied in accordance with the rules applying to allocated pensions/annuities.

The other types of PREPs (eg, market-linked PREPs, lifetime PREPs and life expectancy PREPs) can be stopped only in the first six months. This ability will be lost if the PREP has been purchased by the commutation of another market-linked, lifetime or life expectancy PREP.

The taxation and RBL treatment of PREPs will follow their ordinary pension/annuity counterpart.

For Allocated PREPs, this means the income stream will be assessable (subject to the exempt portion relating to the undeducted purchase price of the pension), and the assessable portion (to the extent that it is not excessive) will be entitled to the 15 per cent rebate. Allocated PREPs will have the same RBL treatment that applies to ordinary income streams.

Are there any clouds on the PREP horizon?

Possibly. The first is that any adviser recommending a PREP must consider the effect of early access to a taxpayer’s superannuation savings. This early access may result in the superannuation savings being exhausted at an earlier age than would otherwise be the case.

The second is whether the Australian Taxation Office will impose rules as to acceptable PREPs and unacceptable PREPs, and attempt to apply or threaten to apply Pt IVA to unacceptable PREPs.

Michael Hallinan is a superannuation and insurance lawyer with Townsends Business and Corporate Lawyers.