Market linked pensions first became available on 20 September 2004. These pensions receive more favourable treatment for social security asset test concessions (i.e. only 50% of the market linked pension’s assets count towards the asset test for an age pension). However, due to changes introduced by the Superannuation reforms in 2007, any new pension commenced in an SMSF after 20 September 2007 were required to be an account based pension. SMSF members can, however, commence a new market linked pension (which will also be 50% asset test exempt) using the balance rolled over from the commutation of an existing market linked pension.
From 1 July 2017, all retirement pensions were counted towards a member’s transfer balance account which is assessed against the general transfer balance cap of $1.6 million (i.e. the maximum amount a member can transfer to the retirement phase). If a member’s transfer balance account exceeds $1.6 million, they must commute their account based pension to reduce their transfer balance account to $1.6 million. However, if the member’s transfer balance account is in excess of $1.6 million due to a market linked pension, it will not create an excess transfer balance. This is in recognition that the market linked pension is non-commutable. Therefore, a market linked pension by itself will not give rise to an excess transfer balance cap.
For market linked pensions, the “special value” is calculated to count towards the transfer balance cap. The special value is determined by multiplying the annual entitlement (first payment divided by the number of days in the first payment period multiplied by 365) by the number of years remaining on the term of the pension (rounded up to a full year). In many cases, the special value calculation results in a higher value than the actual market linked pension account balance.
In addition, as market linked pensions are treated as capped defined benefit income streams, the tax treatment of the pension payment for a member aged 60 and over is that 50% of any payment above $100,000 will be taxed in the member’s hand at their marginal tax rate plus applicable levies. This applies even if the amount is comprised of a tax free component in part or in full. If a market linked pension is commuted, however, and the lump sum resulting from the commutation is applied to commence a new market linked pension on or after 1 July 2017, then the new pension will not meet the definition of a capped defined benefit income stream. This means the new pension will be tested for the member’s transfer balance account in accordance with the general transfer balance cap provisions where the actual market value of the pension assets will be counted as a credit. If the new pension assets have a market value over $1.6 million, it will give rise to an excess transfer balance. As a market linked pension cannot be commuted, this could result in the member being trapped in an excess transfer balance (with associated extra tax payable each financial year) which they may not be able to easily escape.
Is there any benefit in commuting a market linked pension from 1 July 2017?
The amount of a market linked pension that is counted towards a member’s transfer balance cap is the special value which artificially inflates the actual value of the market linked pension. Unless the actual value of the market linked pension exceeds $1.6 million, the member is likely to be disadvantaged from a transfer balance cap perspective in that they can effectively retain less than $1.6 million in the retirement phase. These members may consider commuting and commencing a new market linked pension on or after 1 July 2017. This is so that their transfer balance account credit is based on the account balance at the commencement of their new market linked pension, rather than the special value of their old market linked pension.
Another reason to commute a market linked pension is for the removal of the tax treatment on capped defined benefit income stream pension payments in excess of $100,000. By commuting the pension, members aged 60 and over will receive pension payments from their new market linked pension tax free instead of being assessed at their marginal tax rate on 50% of the amount in excess of $100,000.
However, members need to keep in mind that transferring to a new market linked pension on or after 1 July 2017 will mean that any amount in excess of the transfer balance cap can no longer be ignored. As the new market linked pension is non-commutable, the excess may not be able to be removed and an excess transfer balance tax will accrue.
Something else to be aware of is if a member decides to retain their existing market linked pension, where a reversionary beneficiary receives the member’s market linked pension, the pension will not result in the beneficiary exceeding their transfer balance cap even though it is counted towards their cap. This is even if it exceeds $1.6 million as the modified transfer balance cap provisions will continue to apply.
I recommend SMSF members with market linked pensions seek the advice of a licensed financial adviser prior to taking any action.
Transfer balance cap reporting
Currently there is a problem with how amounts are added to or subtracted from the transfer balance account of a market linked pension when it is fully commuted to acquire a new market linked pension. Under the current law, for the commuted amount to be debited to the transfer balance cap, you must first determine the next payment due from the pension, then annualise the pension amount. The annualised amount is then multiplied by the number of years the pension has left to run.
The problem is that if a market linked pension is fully commuted, there will never be a next payment from the existing commuted pension. Therefore, the next payment will be “nil” and so would be the commutation value for the purposes of the transfer balance cap. This means, the commutation will not result in any reduction in the amount that is counted towards the member’s transfer balance cap. However, the new market linked pension will be credited towards the member’s transfer balance cap. This means, the same money will be counted twice and as a result the member will have an excess transfer balance amount. The government is currently looking at a legislative change to resolve this issue.
ATO SMSF News Alert 2018/3
In the SMSF News Alert 2018/3, the Australian Taxation Office stated they will not take compliance action where an SMSF does not report the transfer balance account events of the commutation or the commencement of the new market linked pension. This is due to the fact that under s294-145(1) of the ITAA 1997, where a market linked pension is commuted on or after 1 July 2017, the transfer balance debit is nil. If the member then commences a new pension, it may cause them to exceed their transfer balance cap or have a higher than anticipated account balance.
In February 2019, the Treasury released draft legislation and regulations to correct an error in the way the market linked pensions are valued under the transfer balance cap when they are commuted or rolled over, that results in a nil debit on the transfer balance account.
It is recommended therefore that SMSF trustees do not report their member’s transfer balance account event – such as commutation of a market linked pension and commencement of a new market linked pension – until the amendments to the relevant law is made.
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