Ensure your pension earnings are tax-free
By Colin Lewis
Superannuation is complex with lots of rules which constantly change and it’s inflexible with your money locked up generally until retirement.
Sounds unattractive, but it is the most tax effective investment vehicle for long-term wealth creation. In accumulation phase, income including capital gains is taxed at only 15 percent. A one-third discount on disposal of assets held for more than 12 months makes the effective tax rate on capital gains only 10 percent.
Withdrawing super – once eligible to access it – from age 60 is tax-free and if you move your super into retirement phase to receive a pension, the earnings including capital gains on investments supporting your income stream are tax-free. You can’t do better than that come retirement!
However, if you’re running a self-managed super fund (SMSF) you must be careful now how you go about claiming this tax exemption on earnings in retirement phase – called exempt current pension income (ECPI). Muck it up and you’ll miss out.
From the 2017/18 income year, getting it right has got more difficult for two reasons. First, industry practice in calculating ECPI has been brought into line with the Australian Taxation Office (ATO) view on how it should be done – previously, there was a mismatch. Second, a new requirement coming out of the superannuation reforms introduced the concept of ‘disregarded small fund assets’.
There are two methods for calculating ECPI – the segregated method and proportionate method.
Generally, the method used depends on whether your fund’s assets are ‘segregated’ – where specific assets supporting your retirement phase income stream are held separate from assets in accumulation phase. Assets are not ‘pooled’.
If your SMSF only pays account-based pensions (ABPs), i.e. there are no accumulation accounts, then the fund’s assets are only supporting retirement phase income streams. These assets are therefore ‘segregated current pension assets’, provided they are not disregarded small fund assets (below), and ECPI is calculated using the segregated method.
Note, if your SMSF is 100% in retirement phase and it receives a contribution or rollover, it ceases to be 100% in retirement phase as the contribution or rollover becomes an accumulation interest. Unless you actively segregate it in a sub-account or separate bank account, you’ll need to switch to the proportionate method.
Income from assets supporting a transition to retirement pension is not ECPI unless it’s in retirement phase.
With the segregated method, all income from segregated current pension assets is ECPI.
Capital gains and losses are disregarded.
You don’t need an actuarial certificate to claim ECPI provided the pension(s) in retirement phase are allocated pensions, market-linked pensions or ABPs. However, if you’re still running a defined benefit pension, then the assets supporting this pension can only be segregated current pension assets if you obtain an actuarial certificate.
With the proportionate method, an SMSF does not set aside specific assets to support retirement phase income streams, rather the fund assets are all pooled together.
An ‘exempt proportion’ – determined by an actuary who provides an actuarial certificate – is applied to the SMSF’s income for the period to determine ECPI.
An SMSF cannot use the proportionate method during periods when the fund has segregated current pension assets.
Disregarded small fund assets
A new rule from the superannuation reforms is the requirement for SMSFs that have ‘disregarded small fund assets’ to use the proportionate method in calculating ECPI for all members for the entire year. The trustees must obtain an actuarial certificate to certify the proportion of income that is exempt.
An SMSF has disregarded small fund assets in an income year if:
- the fund pays a retirement phase income stream anytime during that year, and
- at the previous 30 June, any member had a total superannuation balance (TSB) of over $1.6 million and has a retirement phase income stream in the SMSF or any other fund.
If your SMSF has disregarded small fund assets, then you cannot segregate assets for tax purposes even if your fund is 100% in retirement phase.
It prevents trustees from segregating assets in retirement phase to realise capital gains entirely tax free – having to use the proportionate method means gains are not fully tax exempt.
Over time more SMSFs will have disregarded small fund assets as the $1.6 million figure used in this test is not indexed.
The disregarded small fund assets test imposes an additional administrative burden on SMSFs as it must be done each year to determine how to claim ECPI. Completing the annual return now requires a knowledge of each member’s TSB at the previous 30 June – an understanding of all super accounts held by each member in all funds.
So, you may choose to segregate assets and use the segregated method to calculate ECPI only when your SMSF is paying an ABP(s), is not 100% in retirement phase and does not have disregarded small fund assets.
For any part of the year your SMSF is not 100% in retirement phase and assets are not segregated, the proportionate method must be used and an actuarial certificate is required. The actuary calculates the exempt proportion for that period and applies it to income earned in that period which forms part of the fund’s total ECPI for the year.
If say one member of an SMSF has an ABP and another who’s been in accumulation phase starts an ABP during the year, then the fund may need to switch methods for calculating ECPI if it was using the proportionate method before that pension commenced. Thus, the SMSF will claim ECPI using the proportionate method for the first part of the year and it must use the segregated method for the second part when it’s 100% in retirement phase, provided there’s no disregarded small fund assets.
Ensuring ECPI is claimed correctly is an ongoing area of focus for the ATO. So, it’s critical to get it right.