Superannuation Pensions – Implications of not playing by the rules

Many Australians who are either approaching retirement or have permanently retired from the workforce are running ‘Account Based Pensions’ through their superannuation structures. It is important to understand the rules of running an Account Based Pension in order to avoid potential taxation penalties in the future.

Under the current legislation it is a requirement for individuals to make a minimum drawdown payment from their pension account each financial year. This minimum payment is calculated based on two factors, firstly a percentage factor which is dependent on the member’s age (as detailed in the table below) and secondly the persons account balance.

Age at start of account based pension (and 1 July each year)                      

2012/13
Minimum Drawdown

2013/14
Minimum Drawdown

Under 65

3%

4%

65-74

3.75%

5%

75-79

4.5%

6%

80-84

5.25%

7%

85-89

6.75%

9%

90-94

8.25%

11%

95+

10.5%

14%

The current tax rate that applies to investment income derived from superannuation assets is 15% and the tax rate for realised capital gains is 10% to 15% (depending on whether the asset has been held for more than 12 months).

Once a superannuation fund commences to pay an Account Based Pension, the fund maybe entitled to an exemption on the payment of tax for the investment income and realised capital gains derived from fund assets backing the Account Based Pension. This income is referred to as ‘exempt current pension income’.

For trustees running Self-Managed Superannuation Fund (SMSF), these rules are particularly important given that the ultimate responsibility for making the minimum pension payment each year lies with the trustees.

So what are the implications under the current superannuation regulations if the trustee of the superannuation fund fails to pay the minimum pension?

The pension will be deemed to have ceased for income tax purposes at the start of the financial year (or the start date of the pension if it’s a new pension). As a result, the superannuation fund will not be entitled to treat any investment income or realised capital gains as ‘exempt current pension income’ for that year. Also any payments made to the member during the financial year will be treated as superannuation lump sum payments for both taxation and superannuation purposes.

Under what circumstances will the Australian Taxation Office (ATO) exercise discretion to allow an SMSF to continue to claim the tax exemption on pension income even if the minimum pension payment is not met?

  1. If the SMSF has failed to pay the minimum pension amount due to a trustee error or honest mistake that has resulted in a small underpayment (i.e. is less than one twelfth of the annual minimum payment); and
  2. The entitlement to exempt pension income would have continued but for the trustees failing to make the minimum payment; and
  3. The SMSF endeavours to make a catch up payment as soon as possible (within 28 days of the trustee becoming aware of the underpayment) in the following financial year which would has resulted in the minimum payment being satisfied in the previous financial year; and
  4. The SMSF treats the catch up payment as if it was made in the prior financial year.

Does a superannuation income stream cease in the event of a member’s death if the account based pension does not automatically revert to a dependent beneficiary?

In August 2011 the ATO released a draft tax ruling (TR 2011/D3). The purpose of this ruling was to address ‘when a superannuation pension commences and ceases’. This ruling indicated that superannuation pensions cease as soon as a member dies unless the member had in place a reversionary pension nomination (which means that the pension automatically reverts to a dependent beneficiary upon death). Therefore, in the event that the member did not have a reversionary beneficiary in place, then the member’s assets would revert back to superannuation phase and subsequently loose the tax exempt pension income status. Therefore, should these assets be disposed of, then capital gains tax maybe applicable upon sale at the rate of 10% to 15%. This draft ruling resulted in confusion amongst superannuation advisers.

As a result of this confusion the Government released amendments to the regulations on 29 January 2013 which aimed to clarify that if a superannuation fund member was receiving a pension and then died, the superannuation fund will continue to be entitled to the earnings tax exemption in the period from the members date of death until their benefit is paid out by the fund. This amendment will  be a welcome relief for beneficiaries of death benefits as no capital gains tax will be payable from the superannuation fund when the pension assets are sold or transferred to fund the payment of death benefits.

 

Superannuation earnings tax announced – good investment performance punished

“Stockholm syndrome is the psychological phenomenon where hostages express empathy and sympathy and have positive feelings toward their captors.  These feelings are generally considered irrational in light of the danger or risk endured by the victims, who essentially mistake a lack of abuse from their captors for an act of kindness” (Wikipedia).

As I read through today’s superannuation announcements I experienced a moment of deep gratitude that the Federal Government had been generous enough not to proceed with the most medieval of the options that had been on the table.  I then began to calculate the material disadvantage that will affect families to which these rules apply.  I realised that in my momentary relief, I had forgotten that surely every family in our democracy is entitled to have certainty of outcome under the set of rules that were represented by the Government of the day to apply to their self-funded retirement.  The more I considered the rules, the more I realised how poorly these rules will operate in practice.  Many other ordinary people will innocently get caught in the clutches of these rules at some point.  Make no mistake, as the compulsory Superannuation Guarantee charge increases from 9% to 12% some ordinary individuals will become hostage to these rules.

Superannuation pension earnings tax

From 1 July 2014, future earnings (such as dividends and interest) on assets supporting income streams will be tax free up to $100,000 a year (indexed in $10,000 increments), the balance of earnings will be taxed at 15%.  Remarkably, these rules punish good investment performance.  For example, the Government announcement points out that “(a)assuming a conservative estimated rate of return of 5%, earnings of $100,000 would be derived from individuals with around $2 million in superannuation.  Ergo, if my fund earns 10%, I will be subject to tax once my assets are at the $1 million level.  While the announcement is silent on this point, heaven help me if after 1 July 2014 I buy a capital asset and sit on it for 10 years and then realise a $1 million gain to fund my pension as a one-off.  How does this get taxed?  Will we be averaging over 10 years to $100,000 per year (safe) or is $900,000 of that gain fair game in the year of sale for the higher tax rate.  What about the small business owners that the Government encourages to put their business property into superannuation.  Is that an extra 10% clip of the ticket now when you make a gain on the sale of your warehouse?  Small business already has it hard enough.  If I held that business asset for 15 years outside of superannuation I would pay no tax.  Surely it was not intended that the superannuation system would be an inferior option.

Has the Government forgotten the GFC when there were double digit annual declines in return which depressed superannuation balances and for which superannuation pensioners were not compensated by the tax system.  Now if there is a 20-30% surge forward in one year do people who should not be punished by this system suddenly find they are subject to the system just as they earn their losses back?  Surely not.

I see the need for averaging, as well as extension of small business relief, as items that will rapidly get on the drafting agenda.

Pension withdrawals themselves will not be taxed.

Special transitional rules for capital gains

  • Special arrangements will apply for capital gains on assets purchased before 1 July 2014:For assets that were purchased before 5 April 2013, the reform will only apply to capital gains that accrue after 1 July 2024;
  • For assets that are purchased from 5 April 2013 to 30 June 2014, individuals will have the choice of applying the reform to the entire capital gain, or only that part that accrues after 1 July 2014; and
  • For assets that are purchased from 1 July 2014, the reform will apply to the entire capital gain.

Common sense arrives for “excessive contributions”

Many innocent people have been subject to a punitive rate of tax if they accidentally exceed their concessional contributions threshold.  They get taxed at 46.5% even if their personal tax rate is lower.  Moreover, if the excessive contribution was accidental, it has not been possible to withdraw the excess contribution and correct the error.  Pleasingly from 1 July 2013, it will be possible to withdraw the excessive contributions, be taxed at your ordinary rate with an interest charge on the benefit of a tax timing difference that arises because of the different tax payment dates of the superannuation fund.

In closing, the Government’s announced superannuation reforms are “less bad” than expected. Are we grateful that they are less bad?  Yes.  Can they unfairly single out and materially change the expected retirement income projections for taxpayers who have retired and generated asset balances around $1 million?  Yes, but only if they invest well.  Do they potentially punish people who have balances well under $1 million if they have a good year?  Yes.  Is mediocre performance more likely to avoid the tax than good performance?  Yes.  Oh dear.