In a monthly column to assist trustees, specialist Meg Heffron explores major issues relating to managing your SMSF.
A reader recently highlighted a confusing sentence in an article they’d read and asked what on earth it meant. The sentence in question was:
“They have treated any income stream payment amounts above the required minimum pension as a partial commutation to enjoy a transfer balance cap benefit.”
I can see why that was confusing but it is a sentence that captures a lot of good ideas and is worth unpacking.
Classifying a withdrawal
Anyone with an account-based pension in an SMSF can pretty much take whatever they like out of their pension, unless they haven’t retired yet and their pension is still a 'transition to retirement' pension. And once they reach 60, the tax treatment of payments taken from the account is the same no matter what sort of payment it is.
So why would it matter how the payment is classified?
As the sentence suggests, it’s all about the Transfer Balance Cap (TBC). This is the $1.7 million limit (or somewhere between $1.6 million and $1.7 million for some people) on the amount that can be transferred across to retirement phase pension accounts (pensions for people who have retired) over our lifetime.
The amount transferred across is only checked against the TBC when a pension first starts. Someone whose pension account grows over time doesn’t use up more of their cap when that happens and similarly someone whose pension account drops in value doesn’t automatically get some of their cap back. All that matters is what the pension was worth when it started. So how can payments taken later impact the cap?
An example is the easiest way to explain.
The power of a partial commutation
Mary (65) has $1.8 million in super and starts a retirement phase pension with $1.7 million (i.e., she uses up all of her TBC when her pension first starts). She leaves the remaining $100,000 accumulating in her fund. Each year, she takes exactly what she has to from her pension account (the minimum payment) and when she needs extra money, she takes that from her accumulation account.
Her strategy makes sense. She leaves as much as possible in her pension account so a proportion of her SMSF’s investment income (capital gains, rent, interest, dividends, distributions etc) is tax free. The bigger her pension account, the bigger this proportion. It makes sense to run down her accumulation account rather than her pension account.
But what happens when her accumulation account runs out? At that point she would be taking everything she needs from her pension account.
Let’s say that in a particular year, she needs to withdraw $100,000 but her minimum pension is only $60,000. If she makes a specific choice to treat the extra $40,000 as a payment called a ‘partial commutation’, something special happens. The ATO records this and adjusts her TBC records. Instead of having none of her cap left, she gets $40,000 of it back. This doesn’t happen if she just treats the full $100,000 as a pension payment.
So who cares?
Well, if it’s only ever $40,000, Mary probably doesn’t care. But if this happened a few times and over time her ‘partial commutations’ add up to a more meaningful amount (let’s say $300,000) it does matter.
For a start, getting some of her TBC back means she can start more pensions in the future. If she gets $300,000 back, she can start more pensions with a value of up to $300,000. That might sound completely irrelevant to Mary initially – after all, she doesn’t have any more super.
But what if Mary put more money into super at some point? What if she made a downsizer contribution (special contributions for people who sell their home after owning it for more than 10 years and meeting some other conditions)? A key feature of these contributions is that Mary can make one no matter how old she is and how much she already has in super. Or what if she inherited some super from her spouse? All of these might mean Mary has more super in the future that she’d love to convert to a pension. Getting some of her cap back would help her do that.
Use of standing orders
A common approach for SMSF members is to put standing instructions in place with the trustee. They might read something like this:
“Make sure the minimum amount required is taken from my pension account then take anything extra as a payment from my accumulation account. Once the accumulation account runs out, take anything extra as a partial commutation from my pension account.”
In other words, they don’t have to think about exactly how they want to treat their payments every single time, they just make sure they provide the right instructions in advance.
And the ‘in advance’ bit is important. Legally, a commutation only occurs when a member makes a decision to swap some or all of their future pension payments for a lump sum. It’s not possible to do that after the fact. The member must ask for this treatment to apply up front before taking the payment. Otherwise, any payment from a pension account is just a pension payment.
So for a short sentence, it captures a lot of good ideas for anyone receiving a superannuation pension.
For more explanation on why partial commutations are so powerful, see this article.
Meg Heffron is the Managing Director of Heffron SMSF Solutions, a sponsor of Firstlinks. This is general information only and it does not constitute any recommendation or advice. It does not consider any personal circumstances and is based on an understanding of relevant rules and legislation at the time of writing.
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