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Meg on SMSFs: should I start my pension before selling assets?

In a monthly column to assist trustees, specialist Meg Heffron explores major issues on managing your SMSF.

These days, many SMSF members know that their fund stops paying income tax on some or all of its investment earnings (rent, interest, dividends, capital gains) when it starts paying ‘retirement phase’ pensions.

A ‘retirement phase’ pension is usually a pension that is being paid to someone who is older than 65 or who is slightly younger but is classified as ‘retired’ for superannuation purposes. This particular tax break is one of the greatest benefits of having long term investments in super because it can mean a complete tax exemption on capital gains that have built up over many years.

But is it essential to start the pension(s) before selling the asset? Maybe, maybe not.

Some examples

It’s easiest to explain the rules using examples, and understanding the rules can be incredibly handy.

Let’s start with Craig. In 2020, Craig turned 60 and retired. At the time, he started a pension with all his super (in his SMSF) and so today his fund just has pension accounts (he’s the only member). His fund has owned an investment property for 15 years which it’s about to sell. The property is worth a lot more than his fund paid for it - so will there be a lot of capital gains tax to pay?

In fact, this property can be sold without his fund paying any capital gains tax at all. That’s despite the fact that Craig knows most of the growth in value actually happened before he retired and started his pension. All that’s important is how the fund looks in the year the property is actually sold.

So a great rule of thumb for anyone approaching retirement is to wait and sell SMSF investments after starting pensions if the fund is facing very large capital gains.

But it’s slightly more involved than that.

First of all, Craig’s situation was really simple. He converted all his super into a pension and it happened several years ago. So in his case, all of his fund’s investment income (including all capital gains) are exempt from tax this year.

But what about Craig’s friend Tony? Tony had a very large super balance and wasn’t able to turn all of it into a pension when he retired in 2021. The super tax rules only allow a limited amount – known as the ‘transfer balance cap’ ($1.7 million at the time) – to be put into a retirement phase pension when it first starts. Tony’s super balance was $2 million when he started his pension in July 2021 and so he needed to leave $300,000 out of his pension in an ‘accumulation account’. Today, his super is still split between his ‘pension account’ and his ‘accumulation account’.

The tax for Tony’s SMSF is worked out slightly differently. A percentage (rather than all) of his fund’s investment income is exempt from tax. The percentage is likely to be around 85% for Tony’s fund because his pension account represents around 85% of his total fund. So if his SMSF sold an investment property in 2022/23, 85% of the capital gain would be exempt from tax but the remaining 15% would be taxable.

Even that example is still simple-ish because the pension started in a previous financial year.

What if Craig and Tony only started their pensions in (say) January 2023 and their funds sold property in May 2023?

Craig’s whole fund was still in retirement phase pensions from January 2023 onwards. That means all of its income after that time will be exempt from tax, including the capital gains from the sale of the investment property in May 2023. (Funnily enough, the position might be different if Craig had other super pensions in another fund – but we’ll assume he doesn’t for now.)

In Tony’s case, remember that only a percentage of the capital gain is exempt from tax. Unfortunately, the percentage has to be worked out over the whole year. In this example, around 85% of the fund was in a retirement phase pension for the second half of the year but it was 0% for the first half of the year. So the percentage for Tony’s fund in 2022/23 will only be around 42%. That’s potentially a disaster – only 42% of the capital gains will be exempt from tax. It’s because the percentage that’s being used is very low – dragged down by the fact that Tony only started his pension part way through the year.

In this case, Tony would be better to wait – sell the property early in the new financial year. For 2023/24, the percentage will be more like 85% (as long as nothing else changes – like he stops his pension).

A key tip here is that if a pension starts mid-way through a year, the percentage in that first year is often a lot lower than it will be in the future.

What if Craig and Tony’s SMSFs had sold the property in August 2022 before they started their pensions? At first glance this sounds like a disaster for both of them. But actually it’s not.

In Tony’s case, nothing changes. His percentage is still 42% for 2022/23 (exactly the same) and 42% of all the investment income the fund has earned during the whole year is exempt from tax. Even income it earned before his pension started. And even capital gains like this one.

Craig also has a possible solution. Normally Craig’s SMSF would work out its tax exemption using the method described earlier – all income (including capital gains) after his pension started is exempt from tax and everything beforehand is taxable. But from 2021/22 onwards, SMSFs like Craig’s are allowed to choose to be treated like Tony’s – and use the percentage method. In this case, the percentage would be around 50% (ie his fund was 0% in pension accounts for the first half of the year and 100% in the second half). Just like Tony’s SMSF, this 50% would apply to all investment income for the whole year – both before and after the pension started.

No easy answers

So believe it or not, it’s not always critical to wait until after pensions start to sell assets with large capital gains. But the nuances can be complex – it’s definitely a time when good advice can save thousands in tax.

And one final note : just like everything else with super, there are ifs, buts and maybes. In these examples, Craig and Tony had all their super in their SMSF, they were the only members and they’d never had pensions before the dates talked about in this article. Changing any of these circumstances could change the outcome – definitely talk to your adviser or accountant before going ahead. It’s also worth understanding when assets like property are ‘sold’ for this purpose. It’s when the contract is exchanged, not when the fund gets the money.

 

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.

For more articles and papers from Heffron, please click here.

 

6 Comments
SMSF
August 15, 2023

Thanks Meg for another amazing article! Thoroughly enjoyed the read.

Ted
August 15, 2023

Where does the ATO draw the line on whether a pension (income stream) has been established in good faith?

For example, consider a pension that commenced on 1 July for a member who is fully retired, but in-specie asset transfers took place soon after, with the view to closing the SMSF.

Is it best that the SMSF pays the pension for a full year to ensure it meets the minimum payment standards for that particular member (and ensure that the SMSF continues to attract a nil-tax rate)? Or can the SMSF close within a few months of establishing the pension, and still retain its nil tax rate (up to the TBC)?

Does the ATO require a minimum time frame of, say, 12 months for a trustee to demonstrate that a bona fide pension has been paid

Steve
August 11, 2023

We are living in a financial world that increasingly values complexity over simplicity. At its core, the need for complexity is more often than not stems from an insatiable desire for a tax efficient outcome. We have this myopic view in relation to pension accounts that centres around tax-free earnings. Unfortunately, the downside with pension accounts is that you are mandated to withdraw pension capital each year - more admin. Craig and Tony seem to be experiencing a first world problem. All they are doing is increasing the complexity of their affairs. Lets hope they don't suffer fatal heart attacks in the process. Then what? Good luck sorting out that mess! If Craig and Tony are not worried about longevity risk (i.e. running out of retirement savings), then simply keep retirement assets in accumulation accounts and save everyone the hassle - simple!

Manoj Abichandani
August 10, 2023

I do not understand why sellers think that they will have to pay CGT from their pocket.

For example you have $3.8M and half is in pension and there is only asset - you make a $1 Capital Gain - cost base is $2.8M - there is no cash (whenever the rent comes - after expenses, it is paid as pension).

The tax is 10% (due to 1/rd discount) of half (due to pension) gain or $50,000. Once the $3.8M is received only then $50,000 in tax is paid to ATO. In other words, the buyer is $3,750,000 to the vendor and $50,000 to ATO for the purchase.

That is why, I have no problems in selling - or paying tax - I do not have to pay it - the buyer does.

Rick
August 10, 2023

I realise this article is focussing on minimising capital gains tax when selling assets that are held in Superannuation - specifically the effects on the timing of the sale when a fund transitions to pension phase. However consideration should be given to maintaining funds that exceed the TBC (Craig) to an accumulation account as tax is payable on earnings at 15%. Withdrawing the funds out of the super system will mean tax is payable at his marginal rate, and at the balance used in the example the tax payable on “typical” earnings would be substantially less if no other income was declared.

Rob
August 10, 2023

There is of course an alternative not mentioned for those over the Transfer Balance Cap. "Normal advice" is that a Fund with say $2.5m going into Pension mode would be to "partition" the Fund - ie $1.9m in Pension mode and remaining $0.6m in Accumulation mode. Income tax and Cap Gains paid proportionately

An alternative is to create an entirely new Fund so you end up with the XYZ Pension F and the XYZ Accumulation Fund. Yes there would be additional costs, however depending on quantum and the nature of assets in each Fund, the after tax position may improve.

 

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