The real choice for reasonable benefit limits

Lump sum or pension reasonable benefit limit? Scarcity or abundance? What do you recommend to your clients in relation to superannuation? Grant Abbott puts it to the test with a simple case study.

A new client, John Rogers, has been referred to you. John is 55 and still working in his own business. His wife Jan is aged 49 and she also works in the business.

They take a good wage - $50,000 each year for both of them.

John wants to sell the business in four years time and travel the world. He believes that he will be able to successfully sell the business for a $1 million capital gain. As the business is run in partnership, each spouse will receive $500,000 in capital gains.

On the super front, John has $500,000 accumulated in benefits. Jan has $450,000 in super. John and Jan's lump sum reasonable benefit limit (RBL) is $500,000 and their pension RBL is $1 million. They would like to continue to contribute to super for as long as possible.

It is fairly obvious from the facts of the case that John and Jan have lump sum RBL problems. Given their ages; their desire to contribute further to superannuation; future investment growth on their member balances; and the possibility of taking a CGT exempt component upon disposal of the business in four years time, they will exceed their lump sum RBL by a significant amount.

The question is whether to adopt a scarcity or abundance strategy for John and Jan?

The scarcity solution is to tell both John and Jan that they will exceed their lump sum RBLs and that further contributions to superannuation should not be made.

This will see them paying tax on their distribution or taking out money earmarked for super contributions as salary and wages. A simple strategy - yes. A tax effective strategy - no.

In John and Jan's case there is really no option. We need to look at all available strategies and determine which best suits the client's risk profiles. There are at least seven different strategies that may be used to help alleviate John and Jan's RBL problems. In this issue we will look at two simple abundance strategies.

Strategy One - Dual allocated pensions

Strategy Rating: (((

Benefits:It is simple to use. It ensures that any lump sum commutation, to a certain point, can be made without paying excess benefits tax. It can also be achieved with a public offer fund and a self managed super fund.

Problems:It is imperative to get the RBL reporting right otherwise the Australian Taxation Office (ATO) may brand the wrong pension as excessive. Any commutation payment of the excessive pension on death will render the estate subject to excess benefits tax.

A favourite strategy for many financial planners is based around the client receiving two allocated pensions - an ordinary allocated pension and an excessive allocated pension. For RBL purposes, allocated pensions are tested under the lump sum RBL.

When establishing the two pensions, the financial planner must be extremely careful that the first pension falls under the client's lump sum RBL. Any assessable pension income will be entitled to a full 15 per cent tax rebate and any commutation Eligible Termination Payment (ETP) will not be subject to excess benefits tax.

Once the ordinary allocated pension has been established, the financial planner can use any excess benefits to commence an excessive pension. This second pension misses out on the 15 per cent tax rebate and any commutation from the pension will be an excessive component taxable at 47 per cent (plus Medicare levy).

A significant problem is that the estate will pay excess benefits tax on the second pension. This is a legal suit waiting to happen if the next of kin work out that maybe the excess benefits tax could have been reduced with some proper strategic planning.

Strategy Two - Allocated and complying pension combined

Strategy Rating: ((((

Benefits:Ensures pension income is fully rebatable. Commutation payments, in certain circumstances, can be passed onto beneficiaries and/or the member's estate without tax penalties. This strategy allows client to maximise superannuation benefits without worrying about the pension RBL.

Problems:Complying pension is non-commutable during the life of the pension beneficiary thereby locking them into the pension. This strategy is generally best achieved within a Self Managed Super Fund (SMSF) where the trustee can choose which investments and reserves remaining on the death of the member go to their dependents.

It is a relatively simple process for a financial planner to implement a combination of an allocated and complying pension to beat the lump sum RBL. One of the key conditions that needs to be met in order to access the higher pension RBL is that at least 50 per cent of the member's benefits counted towards their RBL must be used to fund a complying pension. This means that the financial planner seeking to implement this strategy needs to be careful to keep on top of the 50/50 break up. For safety's sake, it is generally best to apply 55 per cent of a member's benefits to a complying pension and 45 per cent to an allocated pension.

Complying pensions offered by life insurers and public offer funds are a simple option for financial planners seeking to adopt an abundance attitude. However, they suffer from the fact that the client generally has no ability to choose the underlying assets funding the pension.

On the other hand, the SMSF option is gaining wide acceptance with the ability of the client trustee to choose the underlying investments funding the income stream. Furthermore, upon the death of the member outside the 10 year commutation period, any surplus benefits in the fund can be allocated by the trustee of the SMSF to a reserve for the benefit of other family members in the fund. This is obviously the better alternative than allowing any of the member's surplus benefits to be allocated to the life insurance companies' reserve for the benefit of strangers.

These two basic examples have challenged the concepts of scarcity and abundance, and although the option of abundance may not be the most flexible or the easiest for the financial planner to administer, the client must come first and foremost.

To find our more, come along to the Money Management sponsored roadshow on RBL planning and estate planning. Invitations are included inside this edition of Money Management.