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Hey baby boomers, pension is not a dirty word

Not everyone looks forward to retirement and starting a pension from superannuation. For some, it is an abrupt reminder they are getting older and it’s time to take things a little easier. However, when it’s a transition to retirement (TTR) pension, things may be seen in a different light. These pensions create the possibility of a tax-effective income stream while continuing to work. Add in the advantages of tax-free income on investments in the fund supporting the pension and it starts to look attractive.

A TTR pension can commence once a person reaches their preservation age as defined in Reg 6.01(2) of the Superannuation Industry (Supervision) Regulations (SISR). The preservation age is 55 for anyone born before 1 July 1960. For anyone born on or after that date, the preservation age increases from 55 to 60 depending on their birth date.

TTR and account-based pensions

A TTR pension has the same features as an account-based pension, but with some additional restrictions. An account-based pension is defined as a pension that meets at least the minimum payment amounts calculated in Schedule 7 of the SISR. It can be transferred to another beneficiary only on the death of the primary or reversionary pensioner (usually a spouse or dependant) and the capital value of the pension, including any income it generates, cannot be used as security for borrowing. The minimum amount of an account-based pension required to be paid during the year is pro-rated on a daily basis. If an account-based pension commences on or after 1 June in a given financial year, there is no requirement to pay any pension until the following financial year.

There are additional restrictions on the maximum amount that can be paid as a TTR pension, and full or partial commutation (conversion to another payment, usually a lump sum). The maximum TTR that can be paid in a financial year, excluding any commutation, is limited to 10% of the pension account balance as at 1 July in that financial year or on the commencement day if the pension started up at a later date during the financial year. There is no requirement for the maximum TTR pension to be pro-rated if it commences during the financial year. There are also rules about how the commuted amount of a TTR can be used.

Is a TTR pension worthwhile?

The first question asked by anyone nearing preservation age should be whether taking a TTR pension is worthwhile. Concessional contributions to the fund are taxed at only 15%, and if they were to receive a fully taxable TTR pension equal to the amount of those contributions, it would be taxed at personal tax rates less a tax offset of 15%.

The main benefit of a TTR pension is that the income on the investments used to support the TTR pension is tax free in the fund. This is an advantage in funds of all sizes as the after-tax rate of return would increase. In addition, any franking credits can be offset against any other tax the fund is required to pay, or any excess refunded to the superannuation fund. There may also be an advantage of delaying the sale of investments with taxable capital gains from the accumulation phase to pension phase because of the tax free status.

Tax savings examples

Let’s consider the example of Lee, who is aged 57 and has a balance of $500,000 in her superannuation fund at the start of the financial year. During the year, she generates assessable income and realised capital gains of 12.5% of the starting balance ($62,500). This amount would be taxed in the fund at 15% ($9,375). However, if Lee had commenced a TTR pension, she would be required to draw a minimum of $20,000 of the balance ($500,000 X 4%) if the TTR pension was payable for the whole year. Any income earned on the TTR pension balance in the fund would be tax free, saving up to $9,375.

Depending on  the taxable and tax free components of the TTR pension, Lee would pay tax at personal rates on the taxable portion of the pension less a tax offset of 15%. If Lee’s minimum TTR pension of $20,000 was fully taxable and she paid personal income tax on it at the rate of 31.5%, the net tax payable would be 16.5% after the tax offset equal to 15%. She would pay tax on the pension of $3,300, far less than the tax saving in the fund. Lee may also wish to salary sacrifice $20,000 to superannuation, taxed in the fund at 15% ($3,000).

The main tax advantage of the arrangement is the tax free status of the income earned by the fund in pension phase. Once Lee reaches age 60, any TTR pension she receives will be fully tax free and the advantages increase substantially.

Any TTR pension must be drawn down in the order prescribed in SISR 6.22A, which requires the unrestricted, non-preserved component of the TTR pension to be drawn first, then the restricted non-preserved benefit and finally the preserved benefit. This issue should be studied more closely by anyone planning a TTR pension.

Commencing a TTR pension may not be best for everyone

There are some reasons not to commence a TTR pension. Retirement savings are drawn out, meaning the amounts saved may run out earlier than if the pension was delayed. A person may not wish to receive additional income as they continue to work because the amount of TTR pension is greater than the amount they can salary sacrifice to superannuation. Plus even in accumulation, the tax rate is only 15% on assessable income, which does not include unrealised capital gains. Each individual needs to work out the relationship between the tax saved in the pension based super fund, versus the additional income tax payable on the pension.

Of course, a pension provides a greater benefit once a person reaches age 60, when no tax is payable on pension income, including TTR pensions. The main benefit of the TTR pension comes not in the receipt of income anyone under age 60, for which the taxable portion is taxed at personal rates less a 15% tax offset. Rather, the main advantage comes from income earned in the fund on the investments supporting the TTR pension being tax free.

From a financial planning perspective, the manner in which the preserved and non-preserved components of the TTR pension are drawn down may also be a consideration, particularly if the pensioner is considering drawing a lump sum from the non-preserved component in future.

Graeme Colley is the Director Technical & Professional Standards at SPAA, the SMSF Professionals’ Association of Australia.

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