These days, many SMSF members know that their fund stops paying income tax on some or all of its investment earnings (rent, interest, dividends, capital gains) when it starts paying “retirement phase” pensions.
A “retirement phase” pension is usually a pension that is being paid to someone who is older than 65 or who is slightly younger but has met the super definition of retirement.
This particular tax break is one of the greatest benefits of having long term investments in super because it can mean a complete tax exemption on capital gains that have built up over many years.
But is it essential to start the pension(s) before selling the asset? Maybe, maybe not.
For example, in 2020, Craig turned 60 and retired. At the time, he started a pension with all his super (in his SMSF) and so August 2022, his fund just has pension accounts (he’s the only member). His fund has owned an investment property for 15 years which it’s about to sell. The property is worth a lot more than when his fund bought it – so will there be a lot of capital gains tax to pay?
In fact, Craig can sell this property without his fund paying any capital gains tax at all. That’s despite the fact that Craig knows most of the growth in the property’s value actually happened before he retired and started his pension. All that’s important is how the fund looks in the year the property is actually sold.
So a great rule of thumb for those approaching retirement is to wait until they start pensions before selling investments in their SMSF if the fund is facing very large capital gains.
But it’s slightly more involved than that.
First of all, Craig’s situation was really simple. He converted all his super (which is all in his SMSF) into a pension and it happened several years ago. So in his case, all of his fund’s investment income (including all capital gains) are exempt from tax this year.
But what about Craig’s friend Tony? Tony had a very large super balance and wasn’t able to turn all of it into a pension. The super tax rules only allow a limited amount – known as the transfer balance cap (currently $1.7m) – to be put into a retirement phase pension when it first starts. Tony’s super balance was $2m at the time and so he needed to leave $300,000 out of his pension in an ”accumulation account”. August 2022 his super is still split between his “pension account” and his “accumulation account”.
In this case, the tax for Tony’s SMSF is worked out slightly differently. In 2022/23, a percentage (rather than all) of his fund’s investment income is exempt from tax. The percentage is likely to be around 85% for Tony’s fund because his pension account represents around 85% of his total fund. So if his SMSF sold an investment property in 2022/23, 85% of the capital gain would be exempt from tax but the rest would be taxable.
Even that example is still simple-ish because the pension started a few years ago.
What if Craig and Tony only started their pensions in (say) January 2023 and their funds sold property in May 2023?
Craig’s whole fund will be retirement phase pensions from January 2023 onwards. That means all of its income after that time will be exempt from tax, including the capital gains from the sale of the investment property in May 2023. (Funnily enough, the position might be different if Craig had other super pensions in another fund – but we’ll assume he doesn’t for now.)
In Tony’s case, remember that only a percentage of the capital gain is exempt from tax. Unfortunately, the percentage has to be worked out over the whole year. In this example, around 85% of the fund was in a retirement phase pension for the second half of the year but it was 0% for the first half of the year. So the percentage for Tony’s fund in 2022/23 will only be around 42%. That’s potentially a disaster – only 42% of the capital gains will be exempt from tax. It’s because the percentage that’s being used is very low – dragged down by the fact that Tony only started his pension part way through the year.
In this case, Tony would be better to wait – sell the property early in the new financial year. For 2023/24, the percentage will be more like 85% (as long as nothing else changes – like he stops his pension).
A key tip here is that if a pension starts mid way through a year, the percentage in that first year is often a lot lower than it will be in the future.
It’s also worth understanding when assets like property are “sold” for this purpose. It’s when the contract is exchanged, not when the fund gets the money.
What if the funds had sold the property in August 2022 before Craig and Tony started their pensions? At first glance this sounds like a disaster for both of them. But actually it’s not.
In Tony’s case, nothing changes. His percentage is still 42% (exactly the same) and 42% of all the investment income the fund has earned during the whole year is exempt from tax. Even income it earned before his pension started. And even capital gains like this one.
Craig also has a possible solution. Normally Craig’s SMSF would work out its tax exemption using the method described earlier – all income (including capital gains) after his pension started is exempt from tax and everything beforehand is taxable. But from 2021/22 onwards, people like Craig are allowed to choose to be treated like Tony’s – and use the percentage method. In this case, the percentage would be around 50% (ie his fund was 0% in pension accounts for the first half of the year and 100% in the second half). This 50% would apply to all investment income for the whole year – both before and after the pension started.
So believe it or not, it’s not always critical to wait until after pensions start to sell assets with large capital gains. But the nuances can be complex – it’s definitely a time when good advice can save thousands in tax.