Segregating pension assets – is it always possible in the first year?

My client will start a retirement phase pension from 1 July and plans to realise a capital gain on a property owned by the SMSF. Can the property be segregated for tax purposes?

A complying superannuation fund that pays a “retirement phase pension” will be entitled to a tax exemption on some or all of its investment income (provided the pension complies with the pension standards in the superannuation law). The technical name for this exempt investment income is “exempt current pension income” (ECPI).

The tax law provides two methods for determining ECPI:

• The “segregated” method where all of the investment income generated from “segregated current pension assets” is completely exempt from tax, and
• The “proportionate” or “actuarial certificate” method where a proportion of the investment income (including realised capital gains) generated from the fund’s assets is exempt from tax.

You can read more about these two methods for calculating exempt current pension income (ECPI) here.

Segregating pensions assets for tax purposes can be desirable as all the investment income generated by the asset (including realised capital gains) will be exempt from tax. However, not all SMSFs will be eligible to use this method. In fact, some SMSFs will only be eligible to use this method in the financial year they first commence to pay a retirement phase pension.

And that’s because the relevant test time that determines whether an SMSF is eligible to use the segregated method for ECPI is at the previous 30 June.

An SMSF that has member balances in both accumulation and retirement phase pension accounts, will still be eligible to use the segregated method despite having a member, at the previous 30 June, with a “total superannuation balance” of more than $1.6m provided the member was not in receipt of retirement phase pensions from any fund (not necessarily the SMSF) at the previous 30 June.

Let’s look at an example of an SMSF that will have a single member (Josie) with $2m in an accumulation account at 30 June 2023. Josie will commence their first retirement phase pension on 1 July 2023 with $1.9m. They have no other retirement phase pensions in any other funds. This means the SMSF would be eligible to use the segregated method for ECPI purposes in the 2023/24 year. This is despite Josie having a total superannuation balance of more than $1.6m at 30 June 2023.

Assuming Josie retains her retirement phase pension and accumulation balance, in the 2024/25 financial year, the fund will not be eligible to continue to use the segregated method if Josie’s total superannuation balance is more than $1.6m at 30 June 2024. This is because Josie had a retirement phase pension in place at the previous 30 June (ie 30 June 2024).

For funds wanting to segregate their assets for tax purposes, in addition to being eligible to use the segregated method, there are other requirements to be met. For example, if a fund trustee wanted to segregate a property as a pension asset, the market value of the property will need to be lower than the value of the retirement phase pension(s). This is because it is not possible to segregate only part of an asset.

Similarly, if an asset is genuinely segregated for supporting pension benefits, then it follows that income from that asset should also be supporting pension benefits. For example, rent will generally be deposited into a bank account that is also a segregated asset and any property expenses would generally also be deducted from the bank account that is a segregated asset. Cash in this bank account would also be used for pension payments.

It is also important the decision to segregate assets is made in advance (requesting specific assets to be segregated does not happen by default or retrospectively) and that appropriate documentation is prepared to record this decision. Usually if a new pension is established with segregated assets, part of the commencement documentation will include a description of the assets set aside to provide it.

Segregation of pension assets may not always be possible but if it is, careful planning is required in advance.

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