SMSF trustees and the pension phase: choosing wisely

Troy Smith explains the options available to SMSF trustees when calculating the amount of tax-free income during the pension phase.

Commencing an income stream in a SMSF is as straghtforward as filling out a form, right? Wrong.

SMSF trustees are responsible for establishing the income stream on behalf of the member. The tasks include confirming the member meets a condition of release, determining a member’s entitlement, calculating the tax components and determining the minimum pension amount — just to name a few.

Another task to be undertaken is calculating the amount of tax-free income on the fund’s investments during the pension phase.

The tax-free amount is technically called the fund’s Exempt Current Pension Income (ECPI). SMSF trustees have the option of using one of two methods to calculate the amount of the exemption — the segregated method or the unsegregated method.

This article broadly explores each method and its relevance to calculating the exemption available to a SMSF paying an income stream.

Segregated method

The segregated method applies to trustees who set aside certain assets and specifically identify income from these assets to support an income stream.

Using this method, trustees are able to establish a clear relationship between the assets and the members pension. The amount of exemption available to the SMSF is based upon the income produced by assets identified to support the pension.

The exemption to this rule is where all members of the SMSF are receiving a pension and the combined account balance of the pensions is equal to the value of the fund’s assets.

In this situation, the Australian Taxation Office (ATO) accepts that the SMSF is not required to identify individual assets, since all the assets of the SMSF are supporting pensions.

Trustees considering the segregated method should consider:

• Different investment strategies. This is more attractive for super fund members where there are different investment strategies for each member, particularly where members are of different ages;
• Ease of understanding. Specifically identifying the assets used to support a pension may make it easier for the members of the super fund to understand who owns which asset; and
• Efficient tax management. The tax exemption extends to both the income and capital gains of assets that support the pension.

Case study 1

The ABC SMSF has assets of $1 million. Joan, who is a member of the SMSF, is commencing an account-based pension using her balance of $380,000.

The trustees of the super fund have decided to use the segregated method and have set aside $380,000 in cash and shares to support Joan’s pension.

Assuming that the SMSF has assessable income of $70,000 (investment returns of 7 per cent on $1 million of assets) and the investments supporting Joan's pension has income of $22,800 (investment returns of 6 per cent of $380,000 of assets) the ECPI is $22,800.

The amount of $22,800 applies as the trustees of the super specifically set aside $380,000 of assets to support Joan’s pension, hence the income derived from these assets is the ECPI.

To determine the taxable income of a super fund, you take into account the assessable income less ECPI.

After applying the ECPI of $22,800 from the fund’s assessable income of $70,000 the ABC SMSF has taxable income of $47,200.

Unsegregated assets

The unsegregated method is when trustees do not specifically set aside assets to support a member’s pension. Trustees of the super fund must determine the amount of exempt income based upon the proportion of the fund’s average value of current pension liabilities compared to its average value of super liabilities.

Trustees considering the unsegregated method should consider the following:

• Actuarial certificate: The ATO requires trustees to obtain an actuarial certificate to certify the amount of the exemption.
• Cost: The cost of running a SMSF under the unsegregated method is generally lower than running it under the segregated method. Even though an actuarial certificate is required to be produced, SMSFs operating under the segregated method usually involve more record keeping.
• Cash flow: The pool of funds available for pension payments includes investment earnings and contributions. This may be of advantage for funds experiencing cash flow issues, where investment earnings are insufficient to meet pension payments, however the fund continues to receive contributions.

Case study 2

Let’s use Joan’s example again with the ABC SMSF that has assets of $1 million. Joan is commencing an account-based pension using her balance of $380,000.

In the previous case study, the trustees of the super fund considered using the segregated method. What happens if the trustees decided to use the unsegregated method to calculate the fund’s ECPI?

Assuming that the SMSF has assessable income of $70,000 (7 per cent of $1,000,000) and the Joan’s pension has income of $22,800 (6 per cent of $380,000) the ECPI is based upon the proportion of average current pension liabilities and average current super liabilities.

The percentage is 38 per cent ($380,000 / $1 million), which results in ECPI of $43,400 (38 per cent of assessable income of $70,000).

After applying the ECPI of $26,600 against assessable income of $70,000 the ABC SMSF has taxable income of $43,400.

Mix and match

SMSF trustees are able to use a combination of both the segregated and unsegregated method for different income streams payable from the fund. This provides significant flexibility to tailor the tax deduction to the member’s income stream.

Capital gains and capital losses

The treatment of capital gains or losses is different for the segregated and unsegregated methods.

Under the segregated method capital gains or loss resulting from the disposal of pension assets are ignored. Any capital loss cannot be offset against any other capital gains.

In contrast, super funds operating under the unsegregated method are required to determine if there is a net capital gain or net capital loss.

A SMSF’s capital gains less any capital losses equals the net capital gains, which is added to the funds assessable income before determining the amount of income that is exempt from tax. A net capital loss can be carried forward to offset future capital gains.

Summary

Trustees need to decide whether operating under the segregated method or unsegregated method is in the best interest of their members. The decision to operate under either method will be a combination of deciding what is appropriate for the members of the super fund, and which method is preferred by the fund’s accountant or auditor.

Trustees who participate in the decision to use one or another method will understand how their hard earned money is being managed. Those who leave the decision-making to others risk being left in the dark.

Troy Smith is a technical specialist at OnePath.