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Meg on SMSFs: should you start a pension before selling assets?

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

Most 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 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.

Starting a pension before selling an asset 

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

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 (August 2022), 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. 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.

Not all cases are so simple

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. The super tax rules only allow a limited amount – known as the Transfer Balance Cap (currently $1.7 million) – 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 (August 2022), 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 will be 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.)

Now the timing becomes tricky

In Tony’s case, remember that only a percentage of the capital gain is exempt from tax. Unfortunately, the percentage must 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% (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.

Not always critical to sell after starting the pension

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. 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 receives 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.

To view Heffron's latest SMSF Trustee webinar, 'Super contributions unpacked', click here (requires name and email address to view). For more articles and papers from Heffron, please click here.

 

17 Comments
angela naidu
August 07, 2022

I have a question-
we have properties under super fund, with the increase in the market - does the increase in market value from one financial year to the other becomes income and we do we have to pay 15% tax. Need advise. I think our self managed super is so complicated.

James
August 07, 2022

Q: "does the increase in market value from one financial year to the other becomes income and we do we have to pay 15% tax?"
A: No. Not unless a property is sold, then 10% CGT in accumulation phase or 0%CGT in pension phase.

Meg Heffron
August 08, 2022

James is right on the tax treatment - to answer your question Angela. I hope your SMSF doesn't always feel this complicated! Perhaps the way to think about it is that retirement planning can be complicated. But some of the considerations here would apply to your super whether it was in an SMSF or another fund. I expect one of the reasons it feels complicated is because the fact that you have an SMSF means you can solve some of the problems created by premature asset sales whereas in a large fund, sometimes you can't. I guess the downside of choice and opportunity is that there's complexity in taking advantage of them and optimising your outcomes. But I hope it ends up being worth it in the end.

Lyn
August 07, 2022

appears to me from all comments here that anything to do with super should only be dealt with by a professional, accredited super expert, as noone 'really knows' the finite details. Why is our system so complicated that no ordinary person can understand it & the varying tax outcomes? Shouldn't we be asking for simple to understand rules?

Dudley
August 07, 2022

"Why is our system so complicated":

Means tested Age Pension. Were Age Pension paid to all living beyond a certain age (Kiwi-isation), then there would be no need for super. Those wanting more cash in retirement than provided by Age Pension could invest after tax savings. Simples!

James
August 08, 2022

'Means tested Age Pension. Were Age Pension paid to all living beyond a certain age (Kiwi-isation), then there would be no need for super."

Labor loves super, the unions love super and the super industry especially loves super. It's a cash cow raining fees and spitting out cash. IMHO we'll never get a non-means tested, universal pension like NZ! Pity!

Gayle
August 06, 2022

A question…in Tony’s case, can he choose to segregate his assets between the pension and accumulation accounts and keep the property and it’s capital gain in the pension fund and have no CGT liability?

Meg Heffron
August 08, 2022

Unfortunately Tony's fund will be one of those that can't "segregate" like this (cherry pick different assets for his pension v accumulation accounts for tax purposes) over the long term. He could do it in the very first year his fund starts a pension but not later - so he'd need to start the pension and sell the property in the same year and it would be important that he didn't have any other super in another fund where a pension had already started in an earlier year. (See my earlier comment for which funds can segregate and which ones can't).

PJ
August 04, 2022

I agree with Tony Carr,

"Craig's friend Tony" could simply roll his $300k accumulation account into an industry fund, leaving his SMSF fund 100% pension.

Adam
August 06, 2022

Transfer Balance cap is total super i.e. all funds, not for each account, so good thinking but no go.

Tony Carr
August 03, 2022

Have you overlooked a plan to have 2 super funds as an option?

Meg Heffron
August 09, 2022

Really good point Tony - 2 funds could be used. Do you mean rolling out the $300k accumulation account to another fund? You absolutely could do that - let's say the $300k is rolled out just before Tony starts his pension. In the very first year his SMSF starts a pension, it can use the segregated method - so he could get to the point where his SMSF is treated just like Craig's (100% pension phase from that point and therefore 100% exempt from tax). In the second year (2023/24), Tony's SMSF would be 100% pension phase all year and therefore all his income would be exempt. One quirk to watch with if Tony rolls out his $300k during the year, though, is that any capital gains he realises on that process would be taxable. That's because they'd happen before the pension started and Tony's SMSF is segregated.

HF
August 03, 2022

With a direct share portfolio I was pleasantly surprised that I could do an in-specie transfer of selected high accumulated CG shares when opening my pension pot......wiping out all the CGT liability on the 1.7M. Though it's this type of thing that makes me think the Super tax breaks need to be looked at.

Graeme
August 04, 2022

I have read that the ATO considers an in-specie transfer to be a disposal for CGT purposes, hence it is taxed the same as any other direct portfolio capital gain.

Alex
August 06, 2022

I'm with Graeme on this - pretty sure an in-specie transfer will generally trigger a capital gains tax event (unless HF was talking about any subsequent capital gains once the assets are transferred into super)

DT
August 08, 2022

Agree HF - where SMSF assets are greater that $1.7m per member, investment segregation of specified fund assets (property or shares) into the pension component at pension inception, would have assisted managing the above property sale in Tony's case. Meg seemed to overlook this option for Tony.

Meg Heffron
August 08, 2022

HF - when you say "in specie transfer", I presume you don't mean an in specie transfer to another fund? Instead, all of this happened within the same super fund ? (ie the transfer was from your accumulation "pot" to your pension "pot")? If so, a few key points : if you did this in a public offer fund, you're probably 100% correct - public funds can do this. If you did this within an SMSF there's an extra quirk : some SMSFs can't "segregate" in this way (pick specific assets to earmark for the pension and have that translate through to how they get taxed). That said, it's often possible for the SMSF to do this in the very first year the first person starts a pension (which sounds like it might be what you did). That's because (weirdly) the rule that stops funds segregating like this is : on the previous 30 June (so 30 June 2022 for any funds starting their first pension in 2022/23) did any member of the fund have at least $1.6m in super (across all funds) AND have a retirement phase pension in place (in any fund)? Funds that answer "yes" can't segregate. If your fund started its very first pension on (say) 1 July, it would be able to say "nope, that doesn't apply to me because my members don't meet the second condition - while they might have had more than $1.6m (as it sounds like you did), they didn't have any pensions in place at the previous 30 June, their pensions only started on 1 July". Hence your SMSF would be able to cherry pick its assets like you've suggested. The catch would be that the NEXT year, you couldn't do that any more (all the assets would have to be shared again). That's because in the next year, you couldn't answer "no" to the above test. So it would only be useful to you to do this segregation if you were also selling them all in that first year.

 

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