When we use the term “segregation” or refer to an asset as being “segregated” in a superannuation fund, we are generally referring to a tax concept which involves setting aside assets to provide retirement phase pensions. But there’s more to it.
In a nutshell, if a fund has assets that are purely supporting one or more retirement phase pension accounts and those assets are classified as “segregated” for tax purposes, the fund claims a tax exemption for all investment income earned on those assets (known as exempt current pension income or ECPI). Providing the fund doesn’t have any defined benefit pensions, it doesn’t even need an actuarial certificate to claim this tax exemption. Other funds that have a mixture of retirement phase pensions and other accounts (such as accumulation or transition to retirement pension accounts) claim their tax exemption using a different method often referred to as the “actuarial certificate method”.
But the Income Tax Assessment Act 1997 also allows trustees to set aside assets exclusively for precisely the opposite purpose – ie to support accumulation (non pension) benefits. Providing the fund is allowed to have segregated assets (see below), assets set aside in this way can be treated as “segregated non-current assets”.
Not surprisingly, earnings on segregated non-current assets are subject to the usual tax rate of 15%. So why would anyone bother – why would a fund choose to isolate some of its assets for the sole purpose of supporting an accumulation account?
Before answering this question, it is important to briefly re-cap which funds are allowed to treat their assets as segregated for tax purposes.
Re-cap – which funds can segregate?
In any given year, an SMSF is allowed to have segregated assets if, at the end of the previous year, no fund member had both:
- A total superannuation balance of more than $1.6m, and
- A retirement phase pension (in this fund or any other).
If a fund is allowed to segregate, the trustee is allowed to have either segregated pension assets or segregated accumulation assets or both.
And when might segregating accumulation assets prove attractive?
This is perhaps best explained using an example.
Consider a fund with two members, both of whom have $1m accumulation balances at the beginning of the year. On 1 January, one of the members starts a retirement phase pension while the other remains in accumulation phase.
In the normal course of events, this fund would obtain an actuarial certificate for the whole year. It is likely that this certificate would show a percentage of approximately 25%. In other words, 25% of all of the investment income received throughout the whole year would be exempt from tax. This would apply to:
- income before any pensions started (when the fund was actually 100% in accumulation phase),
- as well as all income after the pension started (when the fund was actually 50% in pension phase).
If the fund is making roughly the same amount of investment income every month, this will give a result that feels about right.
Where things get complicated is if (say) the fund sells a major property asset in June. Because it occurred at a time when the fund had around 50% of its assets supporting pension accounts, the trustee could be forgiven for assuming that 50% of the capital gains (after discounts) will be exempt from tax.
This is where the ability to segregate an asset to support an accumulation account can be vital.
What if all the fund’s assets were treated as segregated accumulation assets until 1 January?
Since the fund is allowed to segregate its assets for tax purposes, the trustee can elect to treat all its assets as segregated accumulation assets at 1 July until the pension starts on 1 January. Note that this particular election is one that must be made in advance, before the assets become segregated. In this case, that’s on or before 1 July – the trustee couldn’t leave it until later in the year when they realise they won’t get the tax result they hoped for without the segregation.
But doing it helps because it means that:
- the account balances for the first half of the year are completely ignored in working out the actuarial percentage,
- the percentage is therefore higher – in this case, it is likely to be around 50%,
- the percentage is applied to all income after 1 January (all income before that time would be fully taxable).
In this case, it means that 50% of the capital gain (after discounts) would be exempt from tax rather than only 25%.
How are assets segregated for accumulation accounts?
The process is essentially the same as choosing to segregate specific assets for pension accounts (ie the trustee resolves to do so, records the assets that should be treated as segregated assets and ensures that they are kept separate from other assets).
There is one important difference in that funds segregating assets for accumulation accounts must obtain an actuarial certificate. This is different to the situation for funds that are segregating assets for retirement phase pension accounts – as mentioned earlier, this can be done without an actuarial certificate as long as the fund has no defined benefit pensions.
Since segregating assets is almost always talked about in the context of pensions, it is easy to overlook the fact that funds can also segregate assets to support accumulation accounts. The concept can, however, be just as valuable.
We have recently updated our Super Companion Guide, Under the Microscope and Strategies sections for these changes. It’s a resource you really can’t do without if you’re doing 2021/22 tax calculations for SMSFs. Register for the Companion today.