Why partial commutations can improve an SMSF inheritance

We often hear that clients who take more than the minimum required from their pension accounts each year should treat the extra amount as a commutation rather than a pension payment. But when does this really make sense? This is a good idea where the member is likely to make further contributions in the future.

For example, Joe starts his retirement phase account-based pension with exactly $1.6m (100% taxable component) in 2020/21. He has a small accumulation account which he cashes out in the same year.  

He can see that some time in the next few years he’s likely to sell his home and will have the chance to make a downsizer contribution of $300,000. In the meantime, he’s drawing a bit more than the minimum from his pension each year (let’s say the extra is around $30,000 each year) as he gets himself settled in retirement – there are overseas trips to take (COVID-19 permitting), grandchildren to spoil, a new car to buy and actually having fun in retirement, is just a little more expensive than the minimum pension amount. 

Let’s imagine that each year, he treats these extra $30,000 amounts as partial commutations from his account-based pension. That means that each year he claws back some of the $1.6m he’s allowed to put into a pension. After five years have elapsed, he has a transfer balance account of only $1.45m ($1.6m that was added in 2020/21 less five years’ worth of $30,000 partial commutations). When he makes his downsizer contribution in 2026, he finds that he can actually put $150,000 of it into a new retirement phase pension. 

Had he simply treated each of those $30,000 payments as extra pension payments, he would not have had that opportunity.

Going forward, Joe might keep making these commutations for an entirely different reason – tax planning. Joe’s only beneficiaries are his two adult, financially independent daughters. He knows that his original account-based pension will be taxed if they inherit it from him. In contrast, the tax free component that has come about from his downsizer contribution can go to them tax free.

So Joe’s new strategy is to keep treating the extra $30,000 payments as partial commutations (from his original pension). Eventually, he will create enough space in his transfer balance account to start a third pension with the rest of his downsizer contribution. It has grown a bit by then so the new pension is not 100% tax free component but it’s pretty close.

All in all, treating his extra payments as partial commutations has helped him personally and improved the inheritance he will leave for his daughters.

There are another – entirely different – set of benefits for couples who will ultimately inherit each other’s superannuation.

Consider Chris and Jenny who both started their retirement phase pensions with $1.5m and didn’t add any further contributions to their fund over time. Each year, they draw more than the minimum payment requirements (let’s say $20,000 each) and treat these as partial commutations. Five years later, their balances are still around $1.5m (fortunately investment returns have been good and roughly kept pace with their drawings) but they now have transfer balance accounts of only $1.4m (they started with $1.5m but their partial commutations have reduced this amount by 5 x $20,000). Jenny dies and her pension reverts automatically to Chris. Ideally Chris would like to leave as much as possible of Jenny’s balance in superannuation and he’d also like to keep as much as possible of the combined amount ($3m) in pension phase.

He is able to:

• Commute (roll back to accumulation phase) $1.3m from his own pension (leaving $200,000 in place), and
• When Jenny’s pension balance ($1.5m) is added to his transfer balance account 12 months later it takes his transfer balance account up to $1.6m.

This is calculated as follows:

Overall, he would manage to keep $1.7m in pension phase - what’s left of his pension ($200,000) plus the pension he inherited from Jenny ($1.5m).

If, on the other hand, the extra $20,000 each year had all been treated as extra large pension payments rather than partial commutations, the calculations would have been different. He would have needed to roll back $1.4m from his own pension to accumulation phase to make sure his transfer balance account didn’t exceed $1.6m and would have left only $1.6m in pension phase.

Of course, the difference would have been even larger if this arrangement had been in place for many years before Jenny died or if the extra payments had been bigger.

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