Should I wait until July to start my pension?

There has been plenty of press over the last few weeks about the fact that the “transfer balance cap” will increase to $1.9 million from 1^st July 2023.

Remember that this is the limit on how much anyone can put into a super pension after they retire. It started at $1.6 million back in 2017 and increased to $1.7 million in 2021. The next leap up to $1.9 million will be the most significant yet. But only those who don’t start any pensions until 1^st July 2023 get the full increase. Someone who starts a pension now and uses up their full limit of $1.7 million won’t see any increase at all in July. So many retirees with very high super balances who were about to start pensions in their SMSFs are naturally wondering if they should wait.

Believe it or not, it depends.

Those familiar with pensions in SMSFs will be well aware that one of the benefits of starting a pension as soon as possible is that the fund stops paying income tax on some or all of its investment earnings (dividends, rent, interest, capital gains etc).

Just to put some real numbers around that, consider an SMSF with a single member, Joel, who has $2m in super. Let’s say Joel started a pension on 1^st February 2023 with as much as possible at the time ($1.7 million). At the end of the year an actuary will work out what proportion of the fund’s investment income is exempt from tax in that first year – it’s likely to be around 35% of all the income it earned during 2022/23 (even the rent, dividends, interest, gains etc that it earned before the pension started).

(Note that next year the percentage will be even higher - around 85%. It’s lower in the first year to reflect the fact that the pension didn’t start until the year was well progressed.)

If the pension doesn’t start until 1^st July, the SMSF (and therefore the member) will miss out on this tax break. So what is it worth?

That depends on how much income the fund earns in 2022/23. And remember we only look at the income that is taxed – growth in the value of assets doesn’t count (unless the assets are sold of course – because capital gains get taxed).

So let’s say Joel’s SMSF earned around $100,000 in rent, interest, dividends etc during 2022/23 (this equates to 5% of its assets so is probably not a bad starting point). If Joel’s pension started on 1st February 2023, the fund gets to skip paying tax on 35% of this ($35,000). As super funds pay tax at 15%, the value of the tax break is 15% x $35,000, ie $5,250.

But on the flipside, what would be gained by waiting for the transfer balance cap to go up before starting the pension? Well, in that case Joel would be able to put an extra $200,000 into his pension – it would start at $1.9 million rather than $1.7 million. That means in future years the fund will get an even higher tax break on its investment income.

For example, if the pension started at $1.7 million in 2022/23, the SMSF will be able to treat around 85% of its income as exempt from tax in 2023/24. It would be closer to 95% if the pension started at $1.9 million on 1^st July 2023.

So what’s that worth?

If we assume that the fund earns about the same taxable investment income in 2023/24 (say $100,000), the benefit of waiting is around $1,500. I worked this out by saying : the fund can treat an extra 10% (95% - 85%) of its income as being exempt from tax (10% x $100,000 is $10,000). Since super funds pay tax at 15%, Joel’s fund will save $1,500 (15% x $10,000) in the first year if he doesn’t start his pension until 1^st July 2023.

Now of course some kind of saving like this will happen every year – we can’t just compare a single year. If we wait long enough, it’s highly likely that waiting will be a better option.

But a few points leap out.

Firstly, the saving is actually quite small. So those who started their pensions in 2022/23 need not feel they have made a tragic error. Even if we model for 5, 10 or 15 years into the future allowing for all sorts of variables that impact the calculations (for example, future investment returns, pension drawings, inflation and more), waiting is better by thousands or tens of thousands of dollars, not hundreds of thousands.

Secondly, it will take 3-4 years before the savings from waiting until 1^st July 2023 add up to more than the savings from starting on 1^st February. A lot could happen in that time.

Of course, in this comparison we’re looking at someone starting a pension in February – with 5 months left in the current financial year and quite a high percentage of tax exempt income (35%). As we get closer to the end of the year, the decision will be easier (waiting until July will be better). That’s because the actuarial percentage is lower if the pension doesn’t start until later in the year. Someone starting in June, for example, will have virtually none of the fund’s income treated as being exempt from tax in 2022/23. They have nothing to gain by starting early – so it is clearly best to wait until the cap is indexed.

Finally, it very much depends on how much taxable income the fund earns this year vs next year. What if this SMSF had sold a large asset and made a very big capital gain in 2022/23? Perhaps the fund’s taxable investment income is normally around $100,000 but this year it will be $300,000? In that case, the member would probably much rather start their pension as soon as possible to make sure that 35% of $300,000 ($105,000) is exempt from tax – saving $15,750 in 2022/23. If the fund’s income reverts to normal in the subsequent years, it will take many years of $1,500 savings to make delaying more attractive!

Overall, I would say that – all other things being equal – waiting is probably better but not by as much as it might appear. Certainly it will take a while to feel that way and it’s worth doing the calculations to be sure.

For more on pension strategies, there is a wealth of information in the Heffron Super Companion - click to find out more.