SMSF Technical Education & Strategies

 

SMSF reserves - what are they and why would you want one ?

A SMSF reserve is simply an amount of money or assets inside your SMSF that is not part of any member’s account. That is, no one has any entitlement to it yet. Reserves do not make up part of any member’s account balance until they are actually credited or allocated to the member.

As such, the calculation of how much is inside reserves within your SMSF is simply the total value of your SMSF, minus the total value of all member account balances (not including any "suspense accounts" that may exist). To illustrate, this is an example of how a typical family super fund might look with a reserve attached to it.

 

 

 

 

 

Now there are three big questions most people ask at this point:

 

- Why would you want to create a reserve ?

 

- What different types of reserves are there ?

 

- How do you get money into a reserve ?

 

 

Why would you want to create a reserve ?

Believe it or not, although reserves are a fairly new concept for many people with a SMSF, they are actually a very old concept for large superannuation funds, particularly the old defined benefits funds. These funds have used different types of reserves for many years for a variety of reasons, and some of these reasons are just as valid for SMSFs. Whilst the SIS laws do not prescribe any particular purpose or type of reserve, the main reasons for creating reserves include (but are not limited to):

 

Investment smoothing

Investment markets can be volatile, and the return from your investments can be quite variable from year to year. An Investment reserve can be used whereby an allocation is made from this reserve to your SMSF member’s accounts in a year where investment returns are poor. Conversely, in years where the returns are great, a part of this return can be allocated to the investment reserve to be applied in those years when returns are poor.

 

Warehousing contributions

You can warehouse contributions in a Contributions reserve for a term no greater than 28 days after the end of the month in which the contribution was made. Until these amounts are credited to the member's account in the SMSF, they do not constitute part of that member's benefit. Hence, if at the end of the financial year a member has had a concessional contribution made for them say in June, and they have already reached their concessional contribution limit, these contributions can go into the contributions reserve and then allocated to the member account in the following financial year (by July 28).

 

Self Insurance

Self insurance is where your SMSF can fund temporary incapacity, permanent incapacity, and death benefit payments to dependants and/or the legal estate of deceased members. In reality, most people use an insurance policy within the fund for death and permanent incapacity payments, however temporary incapacity is one where self insurance can be quite useful. If money is set aside in a temporary incapacity reserve, then members can received an income from the fund when they meet the temporary incapacity condition of release. See the Insurance section of the site for more details on insurance within your SMSF.

 

Make an anti-detriment payment & obtain a huge tax deduction

On the death of a member, a bonus payment can be made to a dependant or the member's legal estate as compensation for any contributions tax paid by the deceased member, with the fund receiving a large tax deduction for the payment. The question is, where does this money come from ? Over time an anti-detriment reserve can be built up to make this payment when its required. See our separate article on the anti-detriment strategy.

 

How do you get money into reserves?

The main way to get money into a reserve is to allocate investment earnings at the end of each financial year.

For example, say your fund made a 15% return for the year. You could allocate say 10% of that return to member accounts on a proportionate basis, and allocate the remaining 5% to a reserve. There are no hard and fast rules around this - its up to you. You could allocate all of it to a reserve if you wanted to.

 

Of course, contributions can go straight into a contributions reserve but must be allocated to a member account within 28 days after the end of the month that they were contributed.

 

Five other important things to note on reserves:

1. With regard to your trust deed, the SIS Act simply says that the trust deed must not "prohibit" the use of a reserve if your going to use one - however many legal experts say that this does not mean your deed can be silent on the issue. Hence, it would be prudent to ensure your deed allows the creation and maintenance of reserves. Don't just assume it does - check it.

 

2. Investment earnings on the assets in a reserve are taxed just like a regular accumulation account at 15%. This includes funds that are paying out pensions where those pension assets have no tax on earnings.

 

3. If your going to maintain reserves in your fund, then you'll need a "reserve management strategy" that is consistent with the fund's overall investment strategy.

 

4. The maintenance of reserves may increase the work required on your end of year admin, and hence may increase it's cost. If this is correct, you'll need to make a judegment on the extra cost v's the benefit of the reserve.

 

5. When it comes time to allocate money from a reserve to a member's account, there are some rules around this, which if not adhered to may result in the allocation being treated as a 'concessional contribution' and being counted as part of the concessional contributions cap. We'll cover this in a seperate article.