5 tips when partially commuting a pension

5 Oct 2021

Meg Heffron

Managing Director

Pensions can run for many years but that doesn’t always mean that every payment drawn from a pension account is a pension payment. Sometimes lump sums (partial commutations) can be invaluable but it pays to know the rules. These are our top 5 tips.

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We covered a number of tips for fully commuting pensions in our blog here. Some of these apply to partial commutations but there are also a whole lot of other issues to consider.

Partial commutations are in fact very common – particularly these days. That’s because any commutation from a retirement phase pension (i.e. one that has counted towards the member’s transfer balance cap) is treated like a partial reversal of the amount of cap that has been used up. In other words, someone who started a pension with the full $1.7m transfer balance cap amount but then takes a partial commutation of $100,000 is regarded as having used up only $1.6m of their cap. They can top back up to $1.7m in the future by starting another pension with up to $100,000. This ability to create some “space” in the transfer balance cap is extremely useful for people who later make downsizer contributions or inherit a pension from their spouse’s super. For that reason, it’s a common strategy for people with large pension balances to take the minimum amount each year as a normal pension payment but treat any other payments as “partial commutations”.

But what do we need to watch out for?

Unlike a full commutation, it’s not necessary to make sure payments are up to date first. But if they’re not, the trustee has to make sure that there is enough left in the pension account after the partial commutation to still make the full year’s pension payments. And that highlights my first tip – remember that the full year’s payments still have to be paid even after a large partial commutation. There’s no process to reduce the payments required for the rest of the year even if the commutation represented the vast majority of the account.  It’s why it pays to be careful when taking a large partial commutation and converting it to a new pension – the member may effectively end taking pension payments on the same money twice (a full year’s payment from the original pension and then a minimum payment from the new pension).

Tip 2 is related – remember that the partial commutation itself doesn’t count towards the minimum pension calculations. It’s therefore possible to take a huge amount of money out of a pension and yet still fail the minimum payment requirements! Make sure that doesn’t happen.

Bear in mind also that partial commutations can be paid via asset transfers (in specie) whereas pension payments have to be in cash. This can be another reason for treating some payments as commutations – it allows assets to be transferred out of the fund in lieu of a cash payment to the member.

We mentioned in an earlier article (here) that full commutations can create big tax problems. It is because a full commutation means switching off the fund’s entitlement to a tax exemption on investment income (exempt current pension income, ECPI) as soon as the trustee agrees to the commutation. Where the fund is claiming its tax exemption using the “segregated method” rather than getting an actuarial certificate, this will mean that all the income earned after the pension ends is taxable – potentially capturing a lot of capital gains.

But the treatment for partial commutations is quite different. No matter how large the partial commutation, it never causes the pension to end and hence ECPI continues. This is why people wanting to wind up their pension and transfer out all the assets (to themselves or to another fund) will often do this in two steps:

  • Step 1 – a large partial commutation of all the assets with capital gains, so that the gain occurs while the fund is still receiving a tax exemption, followed by
  • Step 2 – paying out the remaining cash as a separate transfer or pension payment.

Thinking carefully about that two step process particularly when winding up funds is my Tip 3.

Tip 4 – like full commutations, partial commutations require a Transfer Balance Account Report (TBAR).

And finally Tip 5 – remember that in an SMSF, if a partial commutation is rolled back into accumulation phase (rather than cashed out or transferred to another fund) it will mingle with any money already sitting in the member’s accumulation account. Most of the time a partial commutation is paid directly out of the fund in which case this isn’t a problem. But if it’s left in the fund, mixing with the accumulation account will also mean mixing the tax components. Like eggs, they can’t be unscrambled.

The ability to partially commute a pension is hugely valuable and is often used treat larger payments more strategically. But it pays to understand the rules. There are some special rules for commutations coming from pensions inherited from someone else when they die and we will cover this in a future article. In the meantime, the ins and outs of pension commutations are covered in our online encyclopedia of superannuation - the Super Companion. Book a free demo or subscribe today.