Winding up market linked pensions – tax component tips

Not surprisingly, we’ve seen a large increase in the number of members with market linked pensions looking to wind them up. As usual, there are some handy hints to think about when doing this.

We covered some of these in an earlier article (Tips for winding up market linked pensions) but let’s unpack some others that relate to tax components.

Most people don’t care much about how their pension account is divided between their “taxable” and “tax free” components during their lifetime. It doesn’t impact the tax they pay personally. However, it becomes highly relevant when the member dies and someone not classified as a dependent for tax purposes inherits the super. Often this is an adult child – and parents do often care about the fact that their children will pay at least 15% tax on the “taxable” component but nothing on the “tax free” component. That can definitely erode an inheritance!

Why is this particularly relevant for market linked pensions? Because it’s entirely possible the market linked pension has very different tax components to the member’s accumulation account. But in the normal course of events, if the market linked pension is fully commuted, the balance will go back into the member’s accumulation account and the two accounts (and their tax components) will be irrevocably combined.

There are some options here. Let’s first look at the scenario where the accumulation account has a higher tax free component (perhaps due to a recent downsizer contribution).

The plan is: the market linked pension will be fully commuted, and some or all of it (as much as possible given the constraints of the transfer balance cap) will be used to start a new account-based pension. There would be nothing to prevent the member starting a new pension from their accumulation account first (picking up the higher tax free component).

For example, Jade has a $2m market linked pension. It’s 0% tax free component.

She also has a $500,000 accumulation account ($300,000 or 60% tax free).

Her accountant has worked out that once she commutes her market linked pension, only $1.2m of it will be able to go back into an account-based pension. (This is a common outcome thanks to the peculiarities of the transfer balance account system.)

She might commence a new account-based pension of $500,000 (60% tax free) first. If she stopped there, she’d have an excess in terms of her transfer balance cap. However, she can – on the same day – fully commute the market linked pension. This will add $2m to her (now empty) accumulation account. She can top up her money in retirement phase pensions by starting a second account-based pension with $700,000 of this (0% tax free). Because transfer balance caps are only checked at the end of each day, she’ll never have an excess. But she’ll end up with much more “tax free” money in super than if she’d simply switched off her market linked pension and started a $1.2m account-based pension without thinking further.

If the tax components are the other way around it’s trickier. Let’s say Jade’s market linked pension is 60% tax free but her accumulation account is 0% tax free.

If she’s close to the point where she’s seriously thinking about winding down her super, now might be the moment. She could fully withdraw her $500,000 accumulation account first and then commute the market linked pension, starting a $1.2m account-based pension immediately afterwards in its place.

If she was really keen to manage her tax components in this way but didn’t want to take anything extra out of super, she could temporarily move part of her balance (say her accumulation account) to another fund. Unfortunately, there’s no simple way to get her new pension from her market linked pension account without passing through her accumulation account first. It’s one of the few times when a public super fund is beneficial – they are allowed to let members set up two accumulation accounts at the same time (whereas members of SMSFs can only have one).

What about someone in a different position?

Casey also has a market linked pension ($600,000, 10% tax free component). But she doesn’t have any super in accumulation phase – she has an account-based pension ($400,000, 20% tax free component). Casey’s not too worried about tax components – she’s pretty confident she’ll spend her super during her lifetime. She’s also in the fortunate position that once she commutes her market linked pension, she’ll be able to put the entire amount back into a new account-based pension. Normally, she would commute her market linked pension and start a new account-based pension in its place. As it wouldn’t be mixing with any existing super in an accumulation account, the new pension would also be $600,000 and have a 10% tax free component. But what if Casey wants to simplify a bit and have a single pension?

This wouldn’t be common in an SMSF – having multiple pensions is easy to manage and most people just leave them as they are. But it can be annoying in a public super fund as each pension account has to be managed separately. This would mean two investment accounts, two different accounts from which pension payments are paid etc.

In this case, Casey can bring the two together by:

• commuting both pensions, combining them in a (temporary) accumulation account, and
• re-starting a $1m account-based pension with the total amount.

This would have tax components that reflect the mix of the two original pension accounts. In other words, the tax free component of the new pension would be:

10% x $600,000 (from the market linked pension) +

20% x $400,000 (from the original account-based pension)

= $140,000

The new $1m pension will therefore be 14% tax free component ($140,000 ÷ $1,000,000).

If you or your client has a market linked pension, we can help in a number of ways – see our range of services here.