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10 tips and traps when starting a pension


Starting and maintaining a pension in a self-managed super fund (SMSF) can be complex.



Moreover, the risks of getting it wrong are serious. For trustees, it pays to ensure they get it right from the start. So here are some tips for trustees to ensure they get it right on a continuing basis.

Above all it’s essential to make sure the tax-free status on investment earnings within pension accounts is maintained. 

1. Check the trust deed 

Financial adviser from AMP Financial Planning, Damian Hearn says the first step is to ensure the trust deed is up-to-date and allows the fund to start a pension. 

“There are many changes happening in the super system that start on 1 July. Trustees can use this as a milestone update their deed, which is your roadmap for running the fund,” he explains.

2. Ensure the member satisfies the condition of release

After the trust deed has been updated the next step is to ensure any members who are preparing to receive a pension satisfy the condition of release. 

These differ depending on the member’s age and status, but generally for members to receive a pension they must have met the preservation age (which depends on your date of birth) and be retired.  

3. Maintain accurate records

Ensure correct documentation is in place to substantiate commencement of a pension. 

This includes ensuring the fund has a written request from the member to the trustee to start the pension, as well as minutes acknowledging and agreeing to the request. 

Notification of a pension agreement sent to the member that outlines the type of pension, as well as its start date and frequency, should also be on file. 

4. Correctly value the fund’s assets

From 1 July this year there will be a $1.6 million cap on the value of the assets supporting a pension. 

Says Hearn: “The ATO is scrutinising this. So it's important fund valuations are correct and reflect the true value of the assets in it.”

Trustees can use market values for assets such as shares, cash, and managed funds. Physical assets such as property require a valuation to be completed. 

5. Determine member benefits

Another essential function is to accurately value member benefits. 

Most pensions commence on 1 July, if not this means the fund will need to have interim accounts prepared so trustees have a complete picture of the assets in the fund, member benefits and their ongoing ability to meet its liabilities (including pension payments).

6. Understand and comply with the new super rules

One of the new rules that applies from 1 July is that tax exemptions on investment earnings won’t apply to transition to retirement pensions. 

Additionally, trustees must stay within the $1.6 million cap described earlier. Exceeding that limit could cause the fund to incur tax liabilities and penalties. 

“It’s essential for trustees to understand where they are against that balance limit and plan for it,” Hearn says.

7. Ensure the fund has sufficient cash available to fund pension payments

A good rule of thumb is to have at least 18 months of cash and available liquid assets such as fixed interest investments, along with strong cash flow within the portfolio. 

For example, if you have a pension in place and the fund’s sole asset is a property, members are likely to experience a liquidity issue at some point.

8. Pay the minimum pension payment

One of the basic requirements when you start a pension is to pay the minimum payment. If you fail to pay the minimum, the pension could be invalid and the investment earnings within the pension may be subject to tax for the full year. 

“We encourage SMSF trustees to make sure they set a reminder in May or June to check they have paid out the required minimum,” says Hearn. 

9. Track the tax components of the pension

Hearn explains when you start a pension it can be made up of a tax-free and a taxable component and it’s essential to document this aspect. 

The risk is that down the track, trustees won’t find evidence of this and may be required to treat the whole pension as taxable, especially when paying lump sum death benefits to adult children.

“Tracking tax components for pensions is essential from an estate planning point of view to avoid paying unnecessary tax,” he adds.

10. Be aware of the consequences of mistakes

There are potentially severe consequences of which trustees should be aware if the fund breaks SMSF rules.

If the fund starts a pension when it shouldn’t, for instance, trustees face the fund losing its complying status as well as other consequences.

“As a trustee, you're bound by trustee fiduciary duties. Don’t put your hard-earned retirement savings at risk by breaching these,” says Hearn.

 
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