SMSF Technical Education & Strategies

 

The lump sum strategy (when used with a pension) for under 60's

by Meg Heffron BEc, FIAA

Heffron Consulting Pty Ltd

In our excitement about the “tax free super for over 60s” rules, it is easy to forget that
clients between 55 and 60 also have an opportunity to secure tax free payments – it is
simply a matter of making use of them.

In this article, we explore a key strategy for making effective use of lump sums – particularly once a pension commences.

Tax treatment of lump sums vs pensions

Before discussing strategies, it is worth highlighting some of the important differences between the tax treatment of superannuation lump sums” and “superannuation income stream benefits”. Note that in both cases – ie, regardless of whether a particular payment is a lump sum or income stream benefit – any tax free component will be taxed in the same way (no tax is payable regardless of the recipient’s age). I have therefore ignored tax free components and focussed initially on the taxable component.

In terms of this component, then, there are some circumstances where it is more attractive to have a particular $1 withdrawal taxed as a lump sum rather than a pension:

• Low rate cap. Any taxpayer over 55 pays no tax on the first $150,000 of any lump sum drawn from the taxable component of their superannuation (note that this is the 2009/10 limit – it was $140,000 in 2007/08 and $145,000 in 2008/09).

Even for those clients who perceive they have already utilised their low rate cap (say via previous lump sum payments), it is worth remembering that the cap is indexed periodically.

For example, a client who withdrew $140,000 in 2007/08 (the limit at the time) now has a further $10,000 available to them as a tax free lump sum. In contrast, the same amount withdrawn as a superannuation income stream benefit by a taxpayer who is still under 60 would be taxed at normal marginal rates less the 15% tax offset.

• 15% (+medicare) rate. Any taxpayer between 55 and 60 (even someone normally on the highest marginal rate) pays only 16.5% tax on a lump sum payment over and above their low rate cap. Hence, those in the 39.5% and 46.5% (including medicare)  brackets have a powerful incentive to have as much of their superannuation taxed as a lump sum (rather than a superannuation income stream benefit) as possible. This is anyone who earns more than $80,000 pa.

Given that it is extremely attractive for superannuation benefits to be taxed in this way between 55 and 60 for a large number of taxpayers, why does it not happen more often? Generally, the reasons given are:

• Lump sums are only available from unrestricted non preserved money – and many clients in that age group have not yet retired; and

 

• There are a great many benefits to having a pension in place (primarily, the ability to generate tax free investment income within the fund) and when faced with choosing one over the other, clients and their advisers will generally opt for a pension.

But is it possible to have the best of both worlds – have a pension and treat payments as lump sums? In short – it certainly can be.

Pension payments taxed as lump sums rather than pensions

SIS requires at least a minimum amount to be paid from a pension each financial year. However, in the case of an account-based pension, SIS Regulation 1.06(9A)(a) simply requires that “the total of payments in any year (including under a payment split but excluding amounts rolled over) is at least the amount calculated under clause 1 of Schedule 7”.

Note that unlike the old rules for allocated pensions, the “payments” do not exclude commutations paid in cash. When it comes to taxing “payments” from a pension, we turn to the Income Tax Assessment Act 1997 (ITAA 1997). Perhaps not surprisingly – given that it is concerned with completely different issues – that Act uses quite different terminology in describing the tax treatment of “pensions”.

For example, the term “pension” is not used at all. Rather, the ITAA 1997 defines two types of payments:

• Superannuation lump sums (taxed using the low rate cap / maximum rate of 16.5% as outlined earlier for those between 55 and 60); and

• Superannuation income stream benefits (taxed at normal marginal rates less the 15% tax offset for those between 55 and 60).

So when is a payment a “superannuation income stream benefit” or a “superannuation lump sum”?

The default position is that any payment from a superannuation income stream (a pension) is a superannuation income stream benefit. This is established in the definition of “superannuation income stream benefit” set out in Regulation 995-1.01 of the Income Tax Assessment Regulations 1997 (ITAR 1997).

However, Regulation 995-1.03 ITAR 1997 provides that a payment from a superannuation income stream is not a superannuation income stream benefit if it comes from an income stream which allows flexible payment amounts (such as an account-based pension) and:

“the person to whom the payment is made elects, before a particular payment is made, that the payment is not to be treated as a superannuation income stream benefit” (Regulation 995-1.03(b))

Any payment that is not a superannuation income stream benefit (whether from a pension or not) is a superannuation lump sum (Section 307-65, ITAA 1997).

Bringing all this together, we can conclude that:

 

• if a payment is made from an ongoing account-based pension, it will be a “superannuation income stream benefit” (taxed like a pension) unless the member specifically chooses beforehand to have it treated as a lump sum; and

• even if the member does make this election (and hence the payment is taxed as a superannuation lump sum), there is nothing in SIS Regulation 1.06(9A)(a) which would stop it being counted towards the minimum pension requirements set out in Schedule 7.

This is a surprisingly profound conclusion. It is new – under the legislation applicable before 1 July 2007, the relevant tax legislation and SIS were more closely aligned. In particular, cash commutations are specifically excluded from payments counting towards the minimum pension requirements in the definition of allocated pension (SIS Regulation 1.06(4)).

For clients under the age of 60, it is possible to use this interpretation to provide a marked difference in the effective rate of tax paid.

Say that Kurt has a pension which consists entirely of a taxable component. He is under age 60 and his balance is $1,000,000. He wishes to draw the minimum possible from his account-based pension – 4% or $40,000 (note that we are ignoring the temporary reduction in minimum pension amounts for the time being). How much tax does he actually have to pay on this drawing?

The table below shows several alternatives:

 

		Tax to pay
Payment is taxed in the normal way – as a superannuation income stream benefit – and Kurt’s marginal tax rate is:
	46.5%	$12,600
	39.5%	$9,800
	31.5%	$6,600
	16.5%	$600
Kurt elects to have the payment taxed as a lump sum		*0 to $6,600

 

* There will be no tax to pay if Kurt has not yet used his low rate cap.

As would be expected, the ability to treat pension payments as lump sums for tax purposes is most attractive to high marginal rate taxpayers and/or those who have not yet used their low rate cap.

Could this even change a client’s decision as to whether or not a pension
starts?

I suspect so.

1. The traditional cost / benefit analysis

Traditionally, the clients with the least to gain from starting a pension are those between 55 and 60 who do not need income and stand to pay the most tax on their pension income. For example, those who:

• have a high income (say the top marginal tax bracket); and

• are already maximizing their concessional contributions to superannuation (hence do not have the opportunity to mitigate the tax on their income by increasing their salary sacrifice contributions).

Clients in this situation will generally only consider a pension because:

• it provides an opportunity to “quarantine” part of their superannuation balance (discussed further in the Recontributions strategy article) and (say) grow their tax free component; or

• the fund then receives its income tax free and in some cases this is sufficiently valuable to outweigh any personal tax cost.

If we consider this latter point, the cost / benefit trade-off is: will the tax saving within the superannuation fund (via a tax exemption on its investment income) be sufficiently high to compensate me for the additional personal tax I pay?

Returning to Kurt, if his marginal tax rate is 46.5% and he starts a pension on 1 July, the personal tax cost for the following year would be:

4% x $1m x (46.5% - 15%) = $12,600*

 

*The figure would be lower in 2009/10 because minimum pension payments are halved this year. However, I have ignored this unique treatment for the time being and instead considered the ‘normal’ situation.

If the fund earns around $50,000 in taxable investment income each year (from dividends, franking credits, rent, interest) then having the fund in pension phase means that no tax is paid on this $50,000 of income – i.e. a saving of :

$50,000 x 15% = $7,500

At this level the pension appears unattractive unless the taxable investment income of the fund is much higher – say large capital gains are realized during the year (perhaps unlikely in the current environment).

2. What if we elect to have all pension payments taxed as lump sums?

Consider now what happens if we combine starting a pre-60 pension with our “use lump sums” strategy. As shown above, the personal tax cost to Kurt would be either:

4% x $1m x 16.5% = $6,600

or potentially $nil if he has not yet used his low rate cap.

This will clearly have a significant impact on Kurt’s decision as to whether or not he starts a pension – particularly if he has not yet used his low rate cap.

 

What about transition to retirement pensions?

The ATO has expressed the view that an individual can only make the election referred to above (ie, to have their pension payments taxed as lump sums) if they are eligible to partially commute their pension. This means that those receiving transition to retirement pensions would only be able to make the election if some of their balance was “unrestricted non-preserved”.

Surely it’s too good to be true?

It would seem so! Bear in mind, however, that it largely arises because the regulations governing pension rules (SIS) do not interact particularly well with the laws governing tax (ITAA 1997). There are also some pitfalls to be wary of:

• The election must occur before the payment is made; and

• The election is only effective while the pension is still in place. If the pension is terminated (fully commuted and paid out in cash or paid out as a death benefit on the death of the pensioner), the election cannot be made and the payment will not count towards meeting the minimum pension requirements.

 

Disclaimer

 

While Heffron believes that the information contained herein is reliable, no warranty is given to the accuracy and persons who rely on it do so at their own risk. This information is intended to provide background information only and does not purport to make any recommendation upon which you may reasonably rely without taking specific advice. In particular, it should not be considered financial product advice for the purposes of the Corporations Act. If you would like more information on this article or any other SMSF information provided by Heffron, please contact them on 1300 172 247 or by e-mail heffron@heffron.com.au