Using Reversionary Pensions in an SMSF

Superannuation funds paying a pension usually pay no tax on the income or capital gains on sale of assets. When the person receiving the pension dies, the fund is considered to have reverted to accumulation phase and is therefore subject to tax again. One solution has been to continue paying the pension to the member’s spouse – this is known as a reversionary pension. Reversionary pension arrangements must be put in place when the pension starts.

In August 2011, the Australian Taxation Office (ATO) issued a draft tax ruling about when a superannuation income stream commences and ceases. The ruling said that a pension was deemed to have ceased “as soon as the member in receipt of the income stream dies”.

Many financial advisers have interpreted that ruling as the ATO imposing a “de-facto death tax” on beneficiaries of superannuation fund members who have died. This is because death benefits to non-dependant beneficiaries must be paid in cash. The assets that were supporting the pension must be sold and because the fund is no longer paying a pension, the fund income is taxable at 15% and any capital gains are taxed at 10%.

The ATO ruling goes on to say that if a dependant beneficiary of the member is automatically entitled to receive an income stream on the death of the member, the fund does not cease being a pension fund. Reversionary pensions suddenly became very popular and advisers were recommending that their clients stop their existing pensions and start reversionary pensions.

As we discussed in the previous article, commuting a pension needs to be done carefully and all the ramifications of doing this must be considered.

In circumstances of minimal impact on the taxable and tax-free components, commuting the existing pension and starting a new one with automatic reversion to the spouse could be a good idea – but check your sums first to make sure. It is important that the trust deed of the fund, your legal will and any binding nominations of beneficiary are carefully examined to ensure that no conflicts are likely to arise that could end up in a court case.

Are you receiving a defined-benefit pension (admittedly rare in a self-managed superannuation fund), a term-life pension or a life-expectancy pension? In these cases, how would you reduce the impact of this ruling if it is not desirable to commute the pension and recommence it? These pensions usually cannot be started again in a self-managed fund.

An alternative approach to stopping a pension and recommencing it as a reversionary pension may be to amend the trust deed of the fund to allow your income stream to continue to be paid to your spouse if certain conditions, such as a minimum period of marriage prior to your death, are fulfilled. Each spouse should also specify to the trustees of the fund that any death benefits they are entitled to receive from the fund should be paid as a pension. Provisions such as this should be reflected in your will. The ruling from the ATO states that this will be considered as an automatic entitlement and the original pension stream will not have stopped.

You should also consider reviewing your investments in your pension fund on a regular basis to determine if substantial capital gains have built up in the fund. In that event, you could consider selling the investments and repurchasing them – on market, of course. This has the effect of crystallising any capital gains and resetting the cost base at a higher level while the fund is still in pension phase. As a result, any subsequent capital gain is minimised.

Another approach if you have significant capital gains, but you also have capital losses that you have been unable to claim, is to commute the fund back to accumulation phase, sell the assets and offset the losses against the capital gains. Then repurchase the investments (if you are happy with them, that is).

The golden rule with all of this is to do your sums before you act, not after.

Sources:
www.ato.gov.au “Draft Taxation Ruling TR 2011/D3 Income Tax: when a superannuation income stream commences and ceases”

Addison Partners has a dedicated team that concentrates on Superannuation lead by superannuation specialist, Jane Thomson. Addison Partners provide advice on developing and implementing superannuation strategies to reduce your tax and increase your savings for retirement. To arrange for a review, please contact your usual Addison Partners contact or call 02 4995 7300 to arrange an appointment.