Getting under the $1.6 million pension balance cap – which pensions should I choose?
For anyone who has more than $1.6 million in pension phase with just one pension, there’s no need to read further. However, if you are receiving more than one superannuation pension, then read on, especially if you expect your adult children to receive some or all of your superannuation benefits on your death or that of your spouse.
Much of the super change discussion going on at the moment is about reducing pension balances to the transfer balance cap, resetting the CGT cost base for investments and making last minute contributions before the caps drop on 1 July. However, no serious consideration has been given to which pensions should be fully or partially commuted to accumulation phase or withdrawn from the fund as lump sums as part of that process.
Anyone with pensions valued at more than $1.6 million on 30 June 2017 will need to work out which pension or pensions should remain in retirement phase and which should be commuted in full or in part to ensure total pension values are within their transfer balance cap.
This may sound relatively simple, however, for some it can have implications, if a pension is intended to be paid to a particular dependant beneficiary or each pension consists of different taxable and tax-free components.
For anyone 60 or over, considering the taxable and tax-free components of a pension may appear irrelevant as most superannuation pensions they receive are tax free and will remain that way under the new rules. However, the taxable and tax-free components of a pension do become important on the death of a fund member, if a benefit is paid to an adult child of the member who is at least 18. In this situation, the taxable component of any death benefit paid to the child is taxed at 15% plus Medicare. However, it is possible to reduce or avoid the amount of tax payable by the adult child with a bit of planning.
As a general rule, a person’s transfer balance cap from 1 July 2017 is $1.6 million, which is the maximum value of pensions that can be transferred to retirement phase after that time, including the value of pensions that were already in place as at 1 July 2017. It is possible for a person to have a higher transfer balance cap if they receive a defined benefit pension because of the restrictions placed on receiving lump sum withdrawals. Defined benefit pensions include many public service pensions, lifetime and life expectancy pensions as well as market linked income streams. Transition to retirement income streams (TRIS) are excluded from being measured against the $1.6 million transfer balance cap, as the income earned by the fund on investments that support a TRIS will be taxed in the fund at 15% from 1 July 2017.
Let’s consider someone who is drawing one account-based pension from their fund that has a balance of more than $1.6 million on 30 June 2017. In that case, the pension must be reduced so that the balance of the pension is no more than $1.6 million by 30 June 2017. Any amount in excess of $1.6 million is required to be transferred to accumulation phase or withdrawn from the fund as a lump sum, otherwise a tax penalty will apply. The taxable and tax-free proportions of the pension remaining in accumulation phase are identical to those calculated at the time the pension commenced.
For someone drawing more than one account-based pension, the total value to be counted against their transfer balance cap on 1 July 2017 must be reduced to $1.6 million, otherwise the tax penalty will be imposed. It is important to consider for estate planning purposes which pension or pensions should be retained or commuted, in full or in part, to reduce the value of amounts counted against the cap to $1.6 million.
This can be illustrated in the case of Rod who is 67, single, permanently retired, has an amount in accumulation phase and is drawing the following account-based pensions from his SMSF:
The total value of Rod’s account-based pensions is $2.6 million which means he must reduce the balance of his pensions in retirement phase by $1 million to get the balances within the $1.6 million cap by 1 July 2017. If this does not take place, Rod will be subject to a tax penalty on the excess.
Let’s assume Rod decided to commute the pensions with the highest tax-free component to get the value of his pensions to $1.6 million. This would leave account-based pensions 1 and 4 in retirement phase and account-based pension 2 would be partially commuted to leave a balance of $100,000. The remainder of account-based pension 2, $500k, as well as account-based pension 3 would be commuted and transferred to accumulation phase or withdrawn from the fund as a lump sum.
After commutation, Rod’s pension and accumulation accounts in the fund would be:
If Rod was to retain the pensions with a 100% tax-free component, on his death, irrespective of the balance the pension balance may have grown so they would continue to retain their 100% tax-free component. For example, if the value of account-based pension No. 4 was to increase to $1 million and was paid to his adult children, the whole amount received would be tax free. This would provide a much more tax advantaged position than if account based pension No. 1 was retained in retirement phase because it consists of a 75% tax-free component. The taxable component of that pension, 25% of the amount received as a death benefit lump sum by an adult child, would be taxed at 15% plus Medicare.
In contrast, the tax position of amounts transferred to accumulation phase and paid out as lump sums determines the taxable and tax-free components in a different way to pensions. With pensions, the taxable and tax-free components are calculated as a proportion of the amount used to commence the pension and these proportions remain constant throughout the existence of the pension. However, amounts in accumulation phase have the dollar amount of any tax-free component fixed and the taxable component is increased by investment earnings arising from the taxable and tax-free components. In other words the taxable component increases, whereas the tax-free component remains constant in accumulation phase.
Therefore, choosing which pensions should remain in retirement phase and which should be transferred to accumulation phase or withdrawn from the fund are an important consideration when it comes to the $1.6 million transfer balance cap, and especially if death benefits end up in the hands of adult children of the pensioner.