While failing to pay the annual minimum pension requirement is not the end of the world, it can certainly create some headaches for SMSF trustees that would be best avoided. Those paying a transition-to-retirement income stream in the accumulation phase face different and possibly more troubling issues than those with account-based pensions in retirement. This article focuses on the ramifications of not quite paying enough.
What the ATO says
The Australian Taxation Office (ATO) released a tax ruling in 2013, ‘TR 2013/5: when an income stream commences and ceases’ that identified the key events that would result in a pension ceasing. There were the common issues such as running out of money and choosing to stop the pension, but among the events was failing to meet the pension standards. In short, the pension standards require that the capital supporting the pension cannot be added to by way of rollover or contribution, the capital cannot be used as security for borrowing purposes, the pension can only revert to certain people on death and that the minimum pension must be paid annually.
How the ATO acts
The position that the ATO took following the release of this ruling is that the pension ceases from the first day of the financial year, not the last. In essence, this means that you won’t know that the pension has ceased until you have made it to 30 June but then the pension is wound back 12 months and treated as an accumulation interest and all benefits that have been paid are treated as superannuation lump sums.
Who’s affected? Who isn’t?
For those SMSF members who have retired and are over the age of 60, this part of the equation may be of little consequence as the benefit will still be tax-free income. Similarly, for those at preservation age (58 or 59 depending on date of birth) that have retired with no intention of being gainfully employed again, failing to pay the minimum will almost exclusively result in drawings below the superannuation low rate threshold, so no significant tax effect will be applied. Therefore, the main issue that arises by failing to pay the minimum becomes the exempt current pension income deduction. If you don’t pay enough, your fund will lose its entitlement to the deduction. The reality of the impact of the loss of that deduction is something often measured in pure tax terms as we are talking about moving from a 0% to a 15% tax environment, however, there are other unintended consequences that are often not considered. Not all the issues are necessarily bad.
Realised capital gains and losses
If a fund is 100% in pension mode, capital gains and losses are ignored. This means that any previously realised capital losses are effectively wasted. In the event that the pension ceases, a fund must start to recognise gains and losses again for tax purposes so any historical losses could be used to offset current gains. This will go some way to offset the move to a taxable environment. It must be remembered that often people hold off from selling investments until they move into a pension so that they pay no capital gains, failing to pay the pension undoes this strategy.
Social security benefits
One area that won’t impact all SMSF members is the Age Pension. Since 2015 SMSF assets are deemed for Age Pension income test purposes, with deeming rates quite low this can be beneficial but they won’t always remain low. Those who started receiving a pension prior to 2015 and were in receipt of the Age Pension calculated their income test differently and these pensions are grandfathered for calculation purposes. Failing to pay the pension will cease this arrangement.
Tax-free vs taxable
Possibly the most significant issue of failing to pay the pension is that as a member’s benefit is considered to be an accumulation interest again, the tax-free and taxable components are no longer fixed until the pension is re-commenced. This means any segregation that was done perhaps for estate planning purposes resulting in split pension interests will be unwound. This can be positive in a year of declining markets as losses will impact an accumulation of members’ taxed component, not the tax-free component. Therefore, in some instances, failing to pay the pension may actually result in a more tax-friendly estate planning position via the reduction of the overall taxable position of the member. That shouldn’t be a reason not to pay the minimum.
Transfer Balance Cap
Unlike the pension exemption ceasing from the start of the year, the transfer balance reporting is done at the end of the year. On the assumption that the member wants to continue the pension the year following the failure to pay, there would need to be a debit to the transfer balance account on 30 June and then a credit to recommence the pension, potentially on 1 July. That reporting has to take into account any movement in the balance that occurred during the year.
Transition to retirement
The problem with the transition to retirement is that a member hasn’t met a condition of release to access their benefits as lump sums. This means that any pension payments that were taken and are now treated as lump sums will be a breach of the law, this may result in further compliance issues.
Rectifying the situation
The ATO has provided a solution for those who fail to pay the minimum on time and the underpayment represents less than 1/12th of the minimum. In this instance, the shortfall must be paid immediately resulting in the pension remaining in place. This opportunity only exists once, if you do it again and in all other circumstances you can contact the ATO and ask for the rules not to apply to you. History will suggest you’ll need a pretty good reason to convince the ATO that the pension hasn’t ceased.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.