Starting a pension is the ultimate plan in a self-managed super fund, but sometimes there are good reasons to stop them. The driver might be a desire to move to another super fund, combine the pension with new contributions or just stop getting so much income from super.Join our newsletter
The technical term when a pension ends in this way is a “full commutation”. Regardless of the reason for your move, there are some important tips to bear in mind.
First, any time a pension stops mid-year, it’s important to make sure the pension payments are up to date. There’s a formula for this purpose but – very broadly speaking – if a pension stops halfway through the year, then half of the year’s minimum payments must be made first.
Second, think carefully about how stopping the pension will affect one of the best tax breaks pension funds get – tax-free investment income. When a pension is fully commuted, it stops being in the pension phase and therefore stops giving the fund any tax exemption on its investment income.
That can be disastrous if it happens at the wrong time. For example, imagine an SMSF with just one pension account. The member has decided to stop the pension and move to another fund so that the SMSF can be wound up. Fortunately, the new fund doesn’t require all the SMSF’s assets to be sold but has agreed to take an “in specie transfer” of the shares and managed funds already owned by the SMSF.
While that sounds great, under the tax rules there’s a clear order of events: the trustee agrees to stop the pension and so it stops; the tax exemption on investment income immediately stops too; and then (finally) the assets are transferred. If the assets have gone up in value since they were first bought, transferring them to a new fund will mean the SMSF realises some capital gains. But by then, the fund is back to paying tax on its capital gains because the pension has stopped.
There are ways to avoid this disastrous outcome, but the key is to be careful about stopping a pension if there are large capital gains involved.
Tip three is tread very carefully when commuting pensions that started before January 1, 2015. Account-based pensions before that time were ignored for the Commonwealth Seniors Health Card. Since this card has no assets test, the generous income test treatment means even people with very large super balances might have access to it. The rules were changed in 2015 and these days a deemed income amount is included for any pensions after January 1, 2015. Even just changing funds or stopping a pension to combine it with new contributions could mean losing access to the card. That’s because both involve using the money to start a new pension.
The risk of double counting
Fourthly, don’t forget to report the commutation to the ATO by preparing a transfer balance account report. The pensioner’s transfer balance account is the running tally of all the amounts that have counted towards the $1.6 million to $1.7 million cap on the amount of super that can be put into a pension over their lifetime. When a pension stops, this running tally is reduced (to reflect the fact that some of their super has been taken out of the pension phase).
Many SMSFs don’t have to report these events until they do their annual tax return. But someone with a large balance who is, for example, winding up their pension to transfer it to another fund is often well advised to bring their reporting forward. This is because the new fund will have to report pretty much straight away. If the SMSF doesn’t also report that the old pension has been switched off, it will look like the member has twice as much in pension phase The ATO might then calculate that they’ve gone over their cap when they haven’t.
Finally, remember that there are times when a pension must be stopped. For example, it’s not possible to add new contributions directly to a pension account. Technically, they go into an accumulation account first and the only way to combine them with an existing pension is to stop the pension and start a new one. Sometimes in an SMSF, it’s actually simpler and safer to convert the new contribution to its own pension instead.
There can be good reasons to stop a pension – it’s just important to handle the process with care. And it’s worth bearing in mind that (like many things with SMSFs), there are actually more choices than just “stopping the pension” or “keeping it running exactly as it is”. There is a halfway house called a “partial commutation” which can be used to great effect to solve some of the problems raised here.
This article was first published in the Australian Financial Review 27th October 2021.