Under the new superannuation law, from 1 July 2017, every SMSF member is limited to $1.6 million in their pension account where the investment income is tax free. Members with amounts in excess of $1.6 million in their pension account are required to either retain the excess in the accumulation phase or withdraw the money as a lump sum benefit. Earnings accumulated in the pension account can remain if the account grows in excess of $1.6 million. However, if the pension account reduces, due to a poor investment performance, members will not be able to “top-up” their pension account back up to $1.6 million.
Things to consider
- SMSF members with multiple pensions can choose which pension to commute. Members under the age of 60 may prefer to commute the pension with the higher taxable component to minimise the tax payable on their pension income.
- Members also need to consider whether their pension commenced prior to 1 January 2015 so as to preserve their entitlements to the age pension and the Commonwealth Seniors Healthcare Card.
- If withdrawing an excess amount (over the $1.6 million cap) from your SMSF, you need to weigh up the benefit of the $18,200 tax free income threshold compared to the 15% superannuation tax rate.
- The new reduced non-concessional contributions limit (i.e. $100,000 pa) may make future contributions to your SMSF more difficult.
The transfer balance cap is indexed in increments of $100,000 in line with Consumer Price Index. If an individual has not fully utilised their transfer balance cap and chooses to transfer their funds, after an indexation increase has occurred, then the balance cap amount will be subject to a proportioning formula based on the highest balance of the member’s transfer balance account compared to the member’s personal balance cap.
(Example 1): Indexation of the balance cap
John commences a pension with an account balance of $1,200,000 in the 2017/2018 financial year. At the time he has utilised 75% of his $1.6 million transfer balance cap. Let’s assume the cap is indexed to $1.7 million in the 2019/2020 year. By applying the proportioning formula, John is entitled to an indexed amount of $25,000:
$1,600,000 – $1,200,000 x $100,000 / $1,600,000 = $25,000
Accordingly, John can commence a new pension with capital of $425,000 (i.e. $400,000 (balance of his $1.6 million transfer balance cap) + $25,000 indexed amount) without breaching his personal transfer balance cap.
Amounts transferred in excess of $1.6 million to the pension account will be subject to an excess transfer balance tax of 15% for breaches in 2017/2018. From 2018/2019, the tax rate is 15% for a first breach, and increases to 30% for second and subsequent breaches. The notional earnings on excess capital is determined by the ATO based on the general interest charge. Transfer balance cap breaches of less than $100,000 at 30 June 2017 are disregarded provided the breach is rectified within six months.
An individual’s transfer balance account is created by the ATO when an individual first commences a pension. If the balance exceeds the cap, the ATO will notify the trustee of the excess amount plus excess transfer balance earnings. The trustee must then commute the excess and can either transfer it back to the accumulation phase or have it paid as a lump sum benefit. An excess transfer balance tax will apply on the notional earnings of the excess portion of the pension. The member has the choice to either pay the tax themselves or arrange for their SMSF to pay the tax and to debit their pension balance.
(Example 2): Excess transfer balance tax
On 1 July 2017, Rebecca commences a pension with $1 million from Fund No 1. On 1 October 2017, Rebecca commences another pension with $1 million from Fund No 2.
This means on 1 July 2017, Rebecca’s transfer balance account is $1 million. Then, on 1 October 2017, Rebecca’s transfer balance is credited with a further $1 million bringing her transfer balance account to $2 million. Rebecca now has an excess transfer balance of $400,000 (i.e. total $2 million in pension accounts – $1.6 million transfer balance cap = $400,000 excess).
On 15 October 2017, the ATO issues an excess transfer balance determination to Rebecca setting out a crystallised reduction amount of $401,414 (i.e. excess of $400,000 plus 14 days notional earnings). Included with the determination is a default commutation authority which lets Rebecca know that if she does not make an election within 60 days of the determination date the ATO will issue a commutation authority to her Fund No. 2 requiring the trustee to commute her $1 million superannuation pension by $401,414.
The transfer balance account operates in a similar way to a bank account where amounts transferred to the retirement phase give rise to a credit and amounts commuted or rolled out of the retirement phase give rise to a debit in the individual’s transfer balance account. Earnings on assets supporting pension liabilities are ignored.
The following items count as a credit towards a member’s transfer balance account:
- the value of all assets supporting pension liabilities on 30 June 2017;
- the capital value of new pensions commenced from 1 July 2017;
- the capital value of reversionary pensions at the time the individual becomes entitled to them (apart from reversionary pensions for children); and,
- notional earnings that accrue on excess transfer balance amounts.
When a commutation occurs, the debit entry to the transfer balance is equal to the amount commuted. Ordinary pension payments do not count as debit entries. The amount of debit applied for a full commutation may exceed the balance of the individual’s transfer balance cap. The debit could be higher (due to growth) or lower (due to draw-downs or losses) than the commencement value of the pension.
There are a limited number of events that may result in an individual losing some or all of the value in their superannuation interests. These include family law payment splits, fraud and void transactions under the Bankruptcy Act 1966.
Fraud: Where a member’s pension is reduced because of a loss suffered as a result of fraud, and the offender is convicted, the member is able to notify the ATO and receive a debit in their transfer balance account for the amount their superannuation was reduced.
Bankruptcy: Where a member’s pension is reduced because of payments required to comply with the Bankruptcy Act (e.g. a contribution was made with the intent to defeat creditors), the member is able to notify the ATO and receive a debit in their transfer balance account for the amount their superannuation was reduced.
(Example 3): How the transfer balance cap is measured
On 1 July 2017, Melinda has a pension account of $800,000 with a Retail Super Fund. In October 2017, Melinda decides she wants to roll-over her pension to her SMSF. On 10 October 2017, the Retail Super Fund commutes Melinda’s pension into a lump sum and sends the amount to her SMSF. The SMSF receives the amount on the same day and immediately starts a new pension for Melinda.
On 10 October 2017, Melinda’s transfer balance account records the following amounts:
- a credit for the Retail Super Fund of $800,000 (dated 1 July 2017), less
- a debit for the commutation of the Retail Super Fund pension for $800,000 (dated 10 October 2017), plus
- a credit to the SMSF pension of $800,000 (dated 10 October 2017).
- The balance in Melinda’s transfer balance account is $800,000 at the end of 10 October 2017.
(Example 4): Commutations
On 1 July 2017, Mark purchases a pension worth $1.6 million. On 1 June 2018, the superannuation interest that supports the pension is valued at $1.7 million because of the investment earnings. Mark fully commutes the pension on this day and receives a $1.7 million superannuation lump sum. Mark’s transfer balance account is debited by $1.7 million to reach a balance of minus $100,000. Mark is entitled to start a new pension worth up to $1.7 million without breaching his transfer balance cap.
Transition to Retirement Income Stream
The Government has removed the tax exempt status from assets supporting a transition to retirement income stream (TRIS) effective from 1 July 2017. The earnings from these assets will be taxed at 15%. TRIS will not count towards the pension transfer cap as funds will remain in the accumulation phase. However, once a member receiving TRIS attains the age of 65 or has fully retired, TRIS will become an ordinary account based pension and the SMSF trustee will need to report the pension to the ATO. From that point on, the pension will count towards the $1.6 million transfer balance cap and the earnings tax exemption will apply to the amount below the cap.
Transitional Capital Gains Tax Relief
The transfer balance cap measure includes a transitional Capital Gains Tax (CGT) relief via a cost base reset. The relief is designed to ensure that only capital growth post 1 July 2017 is taxed. The CGT relief can only be claimed by SMSFs where there is at least one pension in place prior to 9 November 2016 (the date on which the legislation was introduced). An asset must have been held throughout the period 9 November 2016 through to 30 June 2017. The reset can occur at any time during this period after the asset ceased being a segregated current pension asset or otherwise on 30 June 2017 if the unsegregated method is used. Trustees can choose which assets they provide the relief to. Assets acquired after 9 November will not be eligible. An SMSF will need to make an irrevocable election using the ATO’s approved form to reset the cost base of each asset to its market value on 30 June 2017.
Also, where assets are partially supporting accounts in the accumulation phase, tax will be paid on this proportion of the capital gain made to 30 June 2017. This tax may be deferred until the asset is sold. If the member decides to defer the payment of the tax bill until the asset is actually sold, even if they incur a loss in the future, this would not allow them to reduce the “locked in” tax liability up to the reset date. An SMSF that chooses the CGT relief must also wait a further 12 months before it can claim the CGT discount. This is because of the deemed sale of the asset.
In calculating the hypothetical net capital gain of the SMSF, other capital gains and losses that arose during the income year, and prior year unapplied net capital losses, are disregarded. Capital losses are not taken into account in calculating the deferred notional gain but may be applied against the amount when it is brought to account in a later income year. Once the hypothetical net capital gain amount is calculated, the deferred notional gain can be calculated as the non-exempt proportion of the gain. The non-exempt proportion is the amount of the net capital gain that would have been subject to tax if the deferral did not occur. The non-exempt proportion is worked out as the proportion of the SMSF’s unsegregated assets that supported superannuation benefit liabilities throughout the 2016/2017 financial year.
Things to consider
The CGT relief should not be applied to all assets as those currently on unrealised capital losses may be better off to continue carrying the original cost base; whereas, assets with large gains may benefit from the cost base reset on 30 June 2017.
The CGT relief applies differently depending on whether the SMSF segregates assets to support its current pension liabilities or whether it applies the unsegregated/proportionate method.
Segregated current pension assets
An SMSF can only utilise the segregated method if the SMSF asset was segregated prior to 9 November 2016 and the asset ceased to be a segregated pension asset. An asset can cease to be a segregated pension asset if a decision is made to switch to the unsegregated method prior to 1 July 2017. Alternatively, the asset can be switched to accumulation mode prior to 1 July 2017. The criteria for the segregated method is:
- Prior to 9 November 2016, a CGT asset of a fund is a segregated pension asset;
- During 9 November 2016 to 30 June 2017, the asset ceased to be a segregated pension asset;
- The fund held the asset during this period; and,
- The SMSF trustee makes a choice in the approved form before the lodgement of the SMSF’s income tax return for 2016/2017 financial year.
If the above criteria are satisfied, then the SMSF is deemed to have sold and repurchased the asset immediately before 1 July 2017 at the asset’s market value for CGT purposes. Under the segregated method, the entire capital gain is disregarded.
(Example 5): Applying CGT relief to a segregated asset
Tim and Laura have an SMSF. The SMSF holds segregated current pension assets to support Tim’s $2.6 million pension account and segregated non-current assets to support Laura’s $1 million accumulation account.
To comply with the transfer balance cap, Tim partially commutes $1 million of his pension back to the accumulation phase prior to 1 July 2017. The SMSF has two options when adjusting the allocation of assets to its superannuation liabilities that would allow it to claim CGT relief:
Option 1: continuing to use the segregated method until 1 July 2017
On 1 March 2017, to give effect to Tim’s $1 million commutation, the SMSF transfers a segregated pension asset with a market value of $1 million from its segregated pool of exempt assets to its pool of segregated non-current assets. The asset is eligible for CGT relief as it has ceased to be a segregated current pension asset within the 9 November 2016 to 30 June 2017 period.
The CGT cost base for this asset is $750,000 (i.e. unrealised capital gains of $250,000). To ensure that this accrued gain is not taxed when the asset is eventually sold, the SMSF chooses to apply the CGT relief to this asset. The trustees of the SMSF record this choice when they submit the SMSF’s income tax return for the 2016/2017 financial year.
A CGT event occurs in relation to the deemed sale and gives rise to a capital gain of $250,000. However, as this capital gain arises while the asset is still a segregated current pension asset, the gain is exempt from tax.
As Tim’s total superannuation balance is more than $1.6 million the SMSF will be required to use the unsegregated method from 1 July 2017 onwards.
The SMSF sells the asset on 30 March 2018 for $1.15 million. Because the cost base of the asset is now $1 million, the SMSF makes a $150,000 capital gain. The CGT discount applies to the capital gain because the SMSF held the asset for more than 12 months from the time the transitional CGT relief applied. The taxable proportion will reflect the proportion of the SMSF’s superannuation liabilities that relate to Tim and Laura’s accumulation phase interests at the time.
Option 2 – adopting the unsegregated method prior to 1 July 2017
Alternatively, to give effect to Tim’s $1 million commutation, the SMSF could adopt the unsegregated method commencing on 30 June 2017. Under this method, $1.6 million of the SMSF’s total asset (worth $3.6 million) would be considered to be supporting Tim’s pension on this day.
As the asset the SMSF is seeking to apply relief to was a segregated current pension asset just before the SMSF adopts the unsegregated method, it must use the CGT relief provisions relevant to the segregated method. It cannot use the CGT relief provisions relevant to the unsegregated method (even though the SMSF is now applying the unsegregated method) because the asset was a segregated current pension asset at 9 November 2016. The SMSF can choose to apply the relief to some or all of these assets.
The capital gains generated by the application of the relief would be exempt from tax, as these gains would arise while the assets were still segregated.
If an asset to which the relief applied is sold in a later year, a proportion of any net capital gain will be taxable to the SMSF. The taxable portion will reflect the proportions of the SMSF’s superannuation liabilities that relate to Tim and Laura’s accumulation phase interests at that time.
Assets subject to the unsegregated/proportionate method
The criteria for the unsegregated method are:
- The fund has unsegregated current pension liabilities in 2016/2017 financial year;
- The asset is held during the period 9 November 2016 to 30 June 2017;
- The SMSF does not have any segregated pension assets during this period; and,
- The SMSF trustee makes a choice in the approved form before the lodgement of its income tax return for 2016/2017 financial year.
If the above criteria are satisfied, then the SMSF is deemed to have sold and repurchased the asset immediately before 1 July 2017 at the asset’s market value for CGT purposes. As the SMSF is not entirely in pension mode, the notional capital gain on the non-exempt proportion is added to the SMSF’s taxable income for 2016/2017 financial year. The SMSF can, however, defer the notional capital gain that relates to the non-exempt portion until the asset is sold.
Things to consider
Choosing the proportionate method CGT relief may not always produce the best tax result. It will depend on whether an SMSF member proposes to retire and the expected growth of SMSF assets up to that time. For example, if a member is within the $1.6 million cap and will be retiring soon so that their SMSF will be converting to 100% pension mode, choosing to apply the relief to an asset may cause the SMSF to be taxed on the deferred notional capital gain when the asset is sold. This tax would not arise if the relief was not chosen as the pension’s earnings exemption would otherwise apply.
(Example 6): Applying CGT relief to fund using unsegregated/proportionate method
Claire and Ashley have an SMSF supported by a single asset with a market value of $3 million. The SMSF uses the unsegregated method to calculate the proportion of income from the asset that is exempt income, with two thirds of the asset supporting Claire’s $2 million pension and one third supporting Ashley’s $1 million accumulation account.
To comply with the transfer balance cap, Claire partially commutes $400,000 of her pension back to the accumulation phase on 30 June 2017, leaving her with a pension balance of $1.6 million.
The cost base of the asset, acquired in 2010, is $2.82 million (i.e. unrealised capital gains of $180,000). The SMSF trustee chooses to apply CGT relief to ensure the SMSF does not have to pay CGT in the future for the proportion of the asset that supported Claire’s pension (that was commuted as a result of the introduction of the transfer balance cap). The asset is eligible for relief as it was subject to the unsegregated method for the entire pre-commencement period.
The CGT relief provisions deem the asset to be sold on 30 June 2017, and reacquired immediately afterwards, for its market value. This will reset the cost base for the asset to $3 million. It will also reset the 12 month period for the asset to be eligible for the CGT discount.
A CGT event occurs in relation to the deemed sale and a capital gain of $180,000 arises from the event.
If the SMSF does not elect to defer the capital gain, then a capital gain of $40,000 (i.e. $180,000 – 1/3 CGT discount $60,000 = $120,000 x 2/3 ECPI % $80,000) will be brought to account in the 2016/2017 income year.
If the SMSF elects to defer the capital gains, then $40,000 will be locked in and will be added to the SMSF’s assessable income in the year that the asset is sold.
The object of the CGT relief is to support asset reallocations or reapportionments to comply with the transfer balance cap or changes to TRIS. Schemes designed to maximise an SMSF’s CGT relief or to minimise the capital gains of existing assets in accumulation phase, by creating the circumstances in which the choice may be made, may be subject to the general anti-avoidance rules in the Taxation Law. For example, a scheme such as causing an asset with large unrealised capital gains to form part of an SMSF’s segregated current pension asset pool before the 9 November 2016 period, and then causing it to revert to accumulation phase during 9 November to 30 June 2017 would be closely examined. Also, SMSFs should not use commutations of pensions as a mechanism to cycle new assets into the retirement phase. The ATO will also be looking at the strategy of starting a TRIS that has no main non-tax purpose except to secure CGT benefits.
Monica Rule is an SMSF Specialist and author. Her advice is general in nature and you should seek advice that relates to your specific circumstances before making any decisions. www.monicarule.com.au