Almost all pension members will occasionally draw more than the minimum pension amount in a given year. If so, it is critical to think carefully about how those extra payments should be treated and documented before taking the payment.Join our newsletter
Pension members in this position will often look to take their extra payment(s) in several different ways.
They might, in the first instance, take it from their accumulation account if they have one, and many pensioners do. Ever since the $1.6m limit was imposed on the amount that could be moved into a retirement phase pension, SMSF members with large balances have operated at least two accounts in their fund – one for their pension and one for anything over and above the $1.6m they were allowed to put into that pension. The driver for taking extra payments from their accumulation account is simple – this is the account that generates investment income for the fund which is taxed. In contrast, investment income generated by the pension account(s) is exempt from tax (exempt current pension income or ECPI). It is therefore in everyone’s interests to keep the pension account as high as possible (taking the bare minimum from it each year) and taking extra payments from the accumulation account.
Other members will choose to take extra payments from their pension account but treat it as a special payment – a commutation.
A commutation has a unique feature that a normal pension payment does not.
It results in a special reduction (a debit) to the member’s transfer balance account. Someone who takes a commutation from their pension is effectively “given back” some of their $1.6m limit. Even those who are now beyond the age when they might normally make new contributions to superannuation should think carefully before ignoring this. It can be extremely useful, for example, if:
- They do end up making extra contributions – remember that many members who had assumed their contributing days were over might now entertain a downsizer contribution when they sell their home, or
- They inherit superannuation from their spouse. Having as much as possible of their $1.6m limit available can help them take some of that inherited superannuation as a pension. In some cases, it can even make the difference between being able to leave the inheritance in superannuation or being forced to take it out of superannuation as a death benefit. (See our blog on this here )
Even if the ability to claw back some of this $1.6m limit is not attractive, those who wish to take a payment in specie (by transferring their assets to the member rather than paying cash) will need to treat it as a commutation. Only commutations (not pension payments) can be paid in specie.
So it is absolutely vital to be able to specifically decide on how payments from the fund are made up. It must be considered in advance, it is not something that can legally be retrofitted after the year has ended.
Legally speaking, a commutation, for example, is the exchange of future income stream payments for a lump sum “now”. Unless the member specifically requests that (and the trustee agrees) before the payment is taken, it is not a commutation.
But how do we document this in advance when members frequently just withdraw the amount they need and think about how it should be classified later?
The key is in planning at the start of the year.
In almost all cases, it is possible to define the “right” order upfront – a typical approach might be:
- Treat all payments as pensions until the minimum pension requirements for the year have been met, then
- Treat any payments over and above this amount as a commutation from this particular pension, then
- If that pension runs out of money, treat any further extra payments as a commutation from a different pension
and so on.
Importantly, while the numbers might not be known at the start of the year, the way in which the payments should be treated can often be explained conceptually.
This is where some vital documentation comes in – the appropriate requests and trustee agreement to that priority order of payments. This allows the member and trustees to agree in advance that certain payments will automatically be treated as commutations from the pension (or indeed lump sums from an accumulation account).
Note that in 2019/20, well worded documentation would also have automatically accommodated the announcement of reduced minimum pension payments from 25 March 2020.
Take a member whose minimum pension was originally $80,000 but this was halved to $40,000 by the changes in March 2020. The right documentation would automatically have treated any payment on or after 25 March that caused the total to exceed $40,000 (not $80,000) as a partial commutation. Unfortunately no amount of brilliant wording could treat (say) a $60,000 payment in December 2019 as including a $20,000 partial commutation.
Not even Heffron can rewrite history and even documentation like this can only function in line with the law as it stands at the time of each payment.
In our view, this should be standard documentation for virtually all pension funds and it should be reviewed and renewed every year. In our practice we don’t generally prepare this documentation to cover multiple years. Circumstances change, both personally and within the law. Reviewing and re-stating the member’s intentions is something that should happen every year.
We’re often told that trustees don’t want to pay for extra documentation. That suggests they simply don’t understand the benefits. Of all the costs to skimp on, this seems like an odd one to choose. In our experience most practices charge relatively modest amounts for this (say $300 - $400) – often just enough to cover the costs of the additional work involved in reporting commutations to the ATO, carrying out extra calculations for tax components when it comes to withdrawals from accumulation accounts etc.
In a way that makes it even more important that all of us involved in advising them on their SMSF help them to understand why it should be done. There will be nothing they can do if they (belatedly) appreciate its importance many years down the track – say when a spouse dies. A trustee who has decided they want an SMSF and is prepared to pay for one should see this as a great tool in making the most of that decision rather than an optional extra. And when brought face to face with the real value of this documentation they will definitely wonder why they weren’t encouraged more strongly to do it!
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