Properly planning your SMSF

Considering the ever- increasing popularity of self-managed superannuation funds (SMSFs) and the ageing of our population, it is no surprise that the number of SMSFs with pension members is growing strongly. The excitement accompanied by turning 60 and having one’s SMSF enter pension mode (and income stream become tax-free) can be quickly replaced with regret if proper prior planning has not been undertaken. 

Benefits of having a pension

Tax-free income stream

Once you are over the age of 60, pensions from a regulated superannuation fund generally provide a tax-free income stream, whereas income derived from an investment outside the super environment is taxed at your marginal tax rate.

A 15 per cent tax offset applies to the taxable component of a pension received after attaining your preservation age (generally 55 years if born before 1 July 1960). 

Taking advantage of the proportioning rule

The proportioning rule requires that a member’s superannuation benefit be split between a taxable and tax-free component, which must be paid out in the same proportion as the taxable and tax-free components of the member’s interest in the SMSF.

The proportion of taxable and tax-free components for a pension is calculated when the pension is commenced, therefore a pension will lock in your tax-free component as a fixed percentage. In a rising market this is very attractive, because any returns on the pension’s investment will be allocated to the taxable and tax-free components in the same fixed proportion as when the pension started.

In accumulation mode, however, the tax-free component remains nominally static – so when the accumulation balance increases, the tax-free component is diluted and the percentage is reduced.

Thus, locking in a pension sooner rather than later in a rising market is generally more tax-efficient. Moreover, prior planning to maximise the tax-free component by making non-concessional contributions (subject to the contribution caps) prior to starting a pension is popular for this reason. 

Amalgamation – tips and traps

Given the ongoing changes over the past 10 years, there are many members who have more than one pension. They could have multiple pensions with different proportions of taxable and tax-free components. Also, different pensions may need to be treated differently (eg, lifetime pensions, allocated pensions, flexi-pensions or commutable lifetime pensions, fixed-term and market-linked pensions).

People with multiple pensions often seek to simplify their affairs by combining several pensions into one. Moreover, there may be the opportunity of converting an old pension to a modern style pension. For instance, from mid-2007 many have converted their allocated pensions to account-based pensions. Further, many have converted lifetime and fixed-term pensions to market-linked pensions. Naturally, expert advice should be obtained before converting any pension due to the superannuation, taxation, financial, social security and estate planning consequences. This generally involves rolling pensions back into accumulation and then starting a new pension.

But before you jump in and start rolling pensions back, there are a few things to consider. 

Zero accumulation balance

In order to prevent blending the proportions of various pensions’ taxable and tax-free components, it is important that SMSF members generally first exhaust their accumulation balance before rolling back a pension. This allows the amount rolled back to be kept as a separate superannuation interest. 

Have thorough and complete documentation

Ensure that your pension documents show all the rules and provisions of your pension. The Superannuation Industry (Supervision) Regulations 1994 (Cth) call for each requirement of the pension to be included in the pension’s governing rules. In addition, the Corporations Act 2001 (Cth) requires that any new pension interest has a Product Disclosure Statement (PDS) unless it falls under the exemption in s1012D(2A).

Even if an adviser has explained the pension rules in detail to you, it is still important that you are issued with a PDS specific to the pension. If your adviser were to call you a week after they had explained it to you, how much would you remember? 

Know your caps

Often, after rolling back pensions, a member who has reached their preservation age might like to top up their accumulation balance before starting a new pension. This has the effect of increasing the tax-free component of their accumulation balance, which is then locked in once they commence their new pension. However – and this cannot be stressed enough – when withdrawing and re-contributing, be careful to not exceed your caps,  for fear of getting hit with a maximum 93 per cent tax. 

First thing’s first

Using up any pensions with higher taxable components during one’s lifetime to leave tax-free or low-taxed pensions for the longer-term is generally a good strategy. If your pension is not reversionary, its balance will typically return to accumulation mode when you die (this can also happen even if you have nominated a reversionary beneficiary under a reversionary pension). This means that any capital gains realised by the trustee to pay a lump sum will be taxable inside the fund as they are no longer (after the member’s death) covered by the pension exemption. If you have used up all of your pensions with taxable components, and all that remains are pensions that have high tax-free components, the taxable component on death is reduced.

Typically, if there is no surviving spouse, and adult children receive a lump sum, a 16.5 per cent tax applies to the taxable component of a lump sum superannuation death benefit. 

Bankruptcy

Pension payments are treated as income and as such only receive partial protection from creditors. In comparison, an interest in a regulated superannuation fund or a lump sum paid after the date of bankruptcy is fully protected.

The flexibility of account-based pensions to draw down any amount of pension (subject to a minimum amount) has its advantages. However, these advantages can be a double-edge sword when a person is financially stressed. If you become bankrupt, your pension is only partly protected up to a modest income level (eg, an adult with two dependants receives $58,443.75). If your SMSF’s deed does not have adequate provisions to protect you in such a case, a trustee in bankruptcy can potentially step into the bankrupt’s shoes as a member and request the SMSF trustee pay out your entire pension. In particular, any pension payment above the threshold is exposed. 

Binding death benefit nominations

Most people consider that if they make a reversionary pension it is legally binding on the trustee. However, in most cases a reversionary nomination is not legally binding as the trustee generally retains a discretion to revert or commute the pension (and, say, pay out a lump sum). Put simply, a reversionary nomination is generally a mere wish.

A valid binding death benefit nomination (BDBN) will therefore generally override a member’s reversionary wish in their pension documents. Naturally, the precise position needs to be analysed after viewing the particular SMSF deed and BDBN.

One advantage of having a BDBN in place is that it may be used to direct the trustee to pay a particular pension to the member’s chosen dependant. Therefore, the pension documentation will be overridden by the BDBN. This creates a situation where it may be possible for a pension to be reversionary (due to the BDBN) even if there is no reversionary nomination in the pension documentation. This highlights the need for consistency between the BDBN and pension documents. Ideally, every document should be carefully considered and consistent. Otherwise, costly legal challenges may arise. 

The ‘magic boomerang’

In today’s world, it is common for a person to have a partner from a second or subsequent relationship, as well as children from the earlier relationship(s). Say, for example, a father dies leaving children from his first relationship, and his second spouse has her own children from her own first relationship. In this scenario, the father may wish for his pension to go to his second spouse for the rest of her lifetime, and then any capital left on her death to go to his children from his first relationship.

The difficulty with achieving this goal is that, without appropriate legal documents, it relies primarily on the trust and honesty of the second spouse to abide by the deceased spouse’s instructions or wishes.

As most people are aware, a will and a BDBN are freely revocable (eg, the second spouse can revoke her will and BDBN). However, a mutual wills agreement can bind a couple to their mutual promises and undertakings (subject to the practical issues of enforcement).

Moreover, the SMSF deed can be varied to limit a death benefit to be paid as a non-commutable minimum pension to the second spouse (and certain other important limitations to achieve the member’s goals may be included).

While these documents provide greater certainty, there is no way for them to be 100 per cent guaranteed. Therefore, it is worthwhile considering other options. 

The ‘kiss it goodbye’ strategy

This is a method of splitting up one’s superannuation interests into multiple superannuation funds. For example, a father could have two superannuation funds, and upon his second spouse’s death he could leave one interest to her, and the other interest to his children from the first relationship. This provides a more certain distribution of his superannuation interests.

If the father had two SMSFs, he should have two different corporate trustees and ensure his will includes – among other things – specific gifts of the shares to his spouse and children. 

Conclusion

Pensions provide great flexibility and planning opportunities. However, careful planning and the correct documentation are critical. 

Daniel Butler is a director, and Timothy Foster an SMSF consultant, at DBA Lawyers.