Determining an SMSF’s exempt current pension income
The lodgement date for SMSF annual returns for 2024 is approaching unless you established a fund in the 2023-24 financial year and do your own return whereby the due date has passed (October 31).
So, now is a good time to consider the methodology for calculating your fund’s exempt current pension income (ECPI) where it’s running a retirement phase income stream as most trustees have a choice in this matter.
Whilst you may be relying on a professional accountant and actuary to do the work and advise you what to do, it’s not a bad idea to understand what’s going on and what you’re signing off on – after all, you (as trustee or director of the fund’s corporate trustee) are responsible for your fund and make the decision.
It’s widely known that when you commence an account-based pension and move into retirement phase or receive a death benefit pension, that fund earnings, including capital gains, on assets supporting the income stream are tax-free – but this doesn’t just happen. It’s through the calculation of the fund’s ECPI that this tax-exempt income is determined and claimed in the SMSF’s annual return each year.
Earnings on assets supporting a transition to retirement (TTR) pension don’t constitute ECPI unless the pension is in retirement phase – which happens when the member attains age 65 or satisfies a condition of release, e.g. retirement, and notifies the trustee.
Two methods
There are two methods for calculating ECPI – the segregated method and the proportionate (unsegregated) method.
With the segregated method, all income on the assets funding the pension is ECPI and exempt from tax.
Generally, this method is used where the fund is entirely in retirement phase (no accumulation accounts or TTR pensions), or its assets are specifically ‘segregated’, i.e. assets supporting retirement phase pension(s) are held separately from assets in accumulation phase – the assets are not ‘pooled’.
With the proportionate method, an SMSF does not set aside specific assets to support the pension – instead fund assets are all pooled together – and an actuary certifies a percentage of the fund’s income as ECPI. Without an actuarial certificate, ECPI cannot be claimed.
Under tax law, some SMSFs are required to use the proportionate method.
Disregarded small fund assets
The disregarded small fund assets (DSFA) rule prevents some funds from using the segregated method.
This rule was introduced with the July 1, 2017, superannuation reforms to prevent the manipulation of the then new transfer balance cap.
The DSFA rule precludes SMSFs from claiming ECPI under the segregated method where any member of the fund who is in retirement phase – in any fund – has a total superannuation balance of $1.6 million or more at the previous June 30. So, June 30, 2023, for 2024 annual returns.
Completing the return requires a knowledge of each member’s total superannuation balance at the previous 30 June – an understanding of all super accounts held by each member in all funds.
Over time more SMSFs will have disregarded small fund assets as the $1.6 million figure used in this test is not indexed.
Funds caught by this rule cannot assign specific assets to the fund’s pension(s) – for tax purposes – and can only claim ECPI under the proportionate method, generally requiring trustees to obtain an actuarial certificate to certify the proportion of income that’s exempt.
It prevents trustees from segregating assets in retirement phase to realise capital gains entirely tax free – having to use the proportionate method may mean gains are not fully tax exempt.
But there’s an exception to the DSFA rule for funds that only have retirement phase pensions at all times during the year.
A fund that’s 100 per cent in retirement phase for the entire year can still use the segregated method and claim all its investment income as ECPI without the need for an actuarial certificate.
It’s nonsensical to require a trustee to obtain an actuarial certificate when calculating ECPI where all members are wholly in retirement phase for the entire year.
Choice – funds not subject to the DSFA rule
An SMSF might be segregated for part of the year, or it might be for all of it. Some funds experience lots of different phases in the same year.
For SMSFs which have a member(s) in both accumulation phase and retirement phase at one time, but entirely in retirement phase at another time, during the year, the trustees have a choice to either use the proportionate method for the whole year or use both methods at different times of the year, i.e. the segregated method is used whenever assets are entirely supporting retirement phase pensions.
For example, where one member is in retirement phase and another in accumulation phase starts an account-based pension part way through the year, or where an SMSF is 100 per cent in retirement phase and receives a contribution or rollover which goes into an accumulation account – even if that accumulation interest is then used to commence a pension.
For many SMSFs, there won’t be a lot of difference between the methods, so use the one that’s easiest, but for some funds it can make quite a difference.
If you don’t make a choice, the ‘default’ is that the segregated method will be used whenever the assets are entirely supporting retirement phase pensions.
Take an SMSF with two members who started the year entirely in accumulation phase and on October 1, one member commenced a retirement phase pension. On January 1, the second member commenced an account-based pension – at this point the fund was exclusively supporting retirement phase pensions. Then on April 1, the fund received a contribution that was left in accumulation phase, so the fund was back being a mix of pension and accumulation accounts.
The trustee has a choice to use the proportionate (actuarial certificate) method for the whole year or use both methods at different times of the year (default approach).
With the latter, the trustee would use the proportionate method to claim ECPI for July 1 to December 31 and April 1 to June 30, and the segregated method from January 1 to March 31.
For some funds it can be even more complicated, i.e. lots more distinct periods where fund was segregated or unsegregated.
The beauty is you can choose the method for calculating ECPI retrospectively as part of the preparation of your fund’s annual financial statements and SMSF annual return. And you can choose the method that gives the best result.
A different choice can be made each year – it’s not set and forget. So, the choice you may have made for the 2022-23 financial year doesn’t have to apply to the 2023-24 financial year, and the choice you make now for that year doesn’t have to apply next year – allowing you to continually choose the best method to minimise tax.
Where you have a choice of ECPI method, it may mean ‘running the numbers’ before landing on the one which produces the best result.