Separate assets in pension to avoid tax

A member of a self managed super fund (SMSF) currently has an accumulation balance of $400,000. They are 62 years of age, working part-time, and all of their benefits in the fund are unpreserved due to their retirement last year. The fund’s assets are sitting in a number of stocks with large capital gains accrued in respect of the shares.

The proposal by the Government, announced in May this year, to segregate pension assets caused concern for the member. Large capital gains had accrued on the stocks in the fund and meant the trustee of the fund was looking at a capital gains tax bill of $15,000 when the shares were ultimately sold.

At the time of the announcement of the new pension segregation rules, the member and their adviser considered putting in place an allocated pension to commence in June 2000.

The minimum allocated pension payment for a 62-year old in respect of a $400,000 allocated pension at that time, was $23,530.

However, they decided otherwise given that the member did not need the income.

Since then the Government has called a stay in proceedings but the problem will not go away. It is widely expected some form of new taxation rules will be introduced to capture those unrealised capital gains that have accrued on assets at the time of switchover to current pension assets.

The Solution

With the segregation of assets and the capital gains tax rules on the horizon, a temporary solution to the problem may be the use of a short-term pension with a low pension payment. This would ensure that the member gets into the zero taxed pension part of the fund immediately while keeping any pension payment to a minimum.

An example of this type of flexi-pension that may solve the member's problems could be a 5-year, 100% residual capital value (RCV) pension. The term of the pension is flexible and could be lengthened or shortened to meet the member's specific income needs. The more important feature however is the 100% RCV, that is, the member keeps their whole initial capital figure. This lump sum at the end of the pension ensures that any pension payment throughout the term of the pension will be kept to a minimum. Importantly, it also ensures that the member's capital is protected over the term of the pension.

The amount of the pension payment will be determined by the trustee in conjunction with an actuarial report which address, amongst other things, the:

- duration of the pension

- proposed investment strategy for the specific pension

- amount of the residual capital value

- state of the current investment markets

- whether the payments are to be indexed

- size of any current reserve in the fund.

From the trustee's perspective there is generally a degree of flexibility in relation to the size of the pension payments to be made by the trustee of the fund. For a $400,000, 5-year, 100% RCV pension, the actuary may notify the trustee that they will sign off on a pension where the first and subsequent year's pension payments are between $13,600 and $26,500.

It is then up to the trustee to choose the first and continuing pension payments in respect of that pension. If the trustee chose a first and subsequent year pension payment of $14,000 then the amount payable to the member under the pension, including the RCV, would be $14,000 each year for years one to four. In the fifth and final year the payment would be $414,000 as this includes the 100% RCV - the original $400,000 purchase price.

The vehicle -flexi or allocated pension?

The allocated pension is by far the most popular pension in the SMSF market and the most widely used pension by financial planners and accountants. There are also a number of commercial allocated pension products on the market raising the profile of this type of pension.

In contrast, the use of a flexi-pension is still in its infancy. It was introduced into the SIS Regulations in 1994 and we have yet to see widespread use of the flexi-pension.

More planners are beginning to understand the benefits particularly when it comes to estate planning inside a SMSF. Strategically, a flexi-pension is better than the allocated pension when it comes to developing an income stream strategy for a dependant beneficiary of a deceased member.

There are strategic merits for both pensions. In fact, they have many of the same attributes, as shown in the following table:

Pension Comparison - Allocated v. Flexi Pension

Allocated PensionFlexi Pension

Pension PaymentFlexible Fixed

DurationDeath or depletion of capital Flexible: 1 Year to Lifetime

Pension ReversionYes Yes

RCVNo Yes 0-100%

ReservesNo Yes

Able to take Lump Sum (Commute)Yes Account Balance Yes but limited to pension valuation factors

Investment

ChoiceUnlimited Unlimited

RBL TestLump Sum Lump Sum

The commutation amount of an allocated pension is the amount sitting in the member's pension account. In contrast, the total amount that may be commuted under a flexi-pension is limited to the amount of the pension payment at the time of commutation, multiplied by a pension valuation factor (contained in the SIS Regulations). Any excess is to be allocated to amiscellaneous reserve.

Both pensions can be funded by equities, cash, fixed interest, property, warrants and other investments provided that the underlying investment does not breach the in-house assets test.

As noted above, both flexi pensions and allocated pensions are tested, for lump sum RBL purposes. When it comes to working out how much is to be tested, the two pensions are very different. To see how different the two pensions are for RBL testing purposes we need to go back to RBL basics.

<I>Grant Abbott is a director of The Strategist Group.