TAX Alert: Changes to superannuation and estate planning strategies

Mar 26 2017

Publications

Superannuation is a major asset for most Australians and so should be considered when developing their estate planning strategy.  The introduction of the ‘transfer balance cap’ as of 1 July 2017 will often mean adjustments to existing strategies, particularly if the desired outcome is for an income stream to be payable from a superannuation fund (called a pension in this article) to a surviving spouse.

This article discusses the impact of the new law and what should be considered.  It deals only with account based pensions and spouse beneficiaries.  So it does not deal with some other very important aspects eg transition to retirement, defined benefit and market linked pensions, or pensions to children.

The new law

 Very broadly, the new law after 30 June 2017 in relation to pensions is as follows:

  • A person cannot start a pension with an account balance supporting a pension of over $1.6m1(or continue such a pension after 30 June 2017).
  •  This limit is called a person’s ‘transfer balance cap’.
  • When a person starts a pension after 30 June 2017, they will have a ‘transfer balance account’.2 This account keeps track of key events in relation to the person’s pension, to see if the person exceeds their transfer balance cap (eg on starting the pension or later on starting a further pension).
  • If someone exceeds their transfer balance cap, they should take action to rectify the problem (eg commuting part of their pension).
  • If the person does not take action, the Commissioner of Taxation (Commissioner) can force the fund to rectify the problem (by issuing a ‘commutation authority’).
  • Rectification action will involve commuting some or all of the pension to a lump sum.
  • Except in relation to pensions resulting from the death of a member, such a commutation can generally be retained in the superannuation system.

Examples relating to the new law

Some examples of how the new law applies (not dealing with death benefits) are as follows:

  • Fred starts a pension after 30 June 2017 with an account balance of $1.6m. His transfer balance cap is $1.6m and the credit to his transfer balance account is $1.6m.  The credit does not exceed his transfer balance cap.  So Fred will comply with the new law.
  • Say Fred’s pension account becomes $2m with growth 2 years after starting his pension. If Fred commutes his pension, he will receive a debit to his transfer balance account of $2m.  This will result in a negative $400,000 balance.3  It will also mean that Fred can start a new pension with $2m (that will be a credit to his transfer balance account, but with the negative $400,000 balance that he had, he will not exceed his transfer balance cap of $1.6m).
  • Say Fred’s pension account instead becomes $600,000 2 years after starting his pension (eg after taking into account pension payments and decease in value of assets). If Fred commutes his pension, he will receive a debit to his transfer balance account of $600,000.  This will result in a $1m balance.  It will also mean that Fred can start a new pension with $600,000 (as then that will be a credit to his transfer balance account, and with the $1m balance that he had, he will not exceed his transfer balance cap of $1.6m).

The current law for payment of death benefits

Where an individual has a superannuation interest when they die, superannuation fund trustees are required to cash the remaining interest from the superannuation system as soon as practicable.4  This can be as a lump sum or pension to permitted beneficiaries (eg spouses).

The new law for the payment of death benefits

The above principle will not change under the new law.  In fact, the new law reinforces this principle.

Current strategies

With spouses, current strategies generally involve keeping a deceased member’s superannuation in the superannuation system for as long as possible.  This will often mean paying the surviving spouse a pension, so keeping the deceased’s superannuation in the superannuation system.  Such a pension may be a ‘reversionary pension’ (eg the deceased had started a pension and a term of the pension is that it must continue to be paid to the surviving spouse), or a ‘non-reversionary pension’ (eg the deceased was still in accumulation mode and the trustee exercises a discretion to pay a pension to a surviving spouse, or the deceased was receiving a pension but on the deceased’s death the trustee has a discretion about how to deal with the deceased’s superannuation).

Generally, when the pension is paid to the spouse, the fund will be tax free (at least in part) and the spouse will often receive the pension payments tax free (though depending on the type of fund and the age of the deceased and sometimes the age of the spouse).  No limits apply to what can be paid as a pension to a surviving spouse.

Impact of the new law on current strategies

The new law significantly impacts on these strategies.  At a very high level, the effects of the new law include:

  • It will often be very difficult for a deceased member’s superannuation to remain in the superannuation system. Often, the deceased’s superannuation will need to be paid out as a lump sum after the deceased’s death.
  • Whether there will be an excess of superannuation in pension mode (ie a transfer balance account in excess of the transfer balance cap) will be determined by the circumstances of the recipient spouse. So, broadly, the pension flowing from the deceased’s superannuation is reassessed for compliance with the transfer balance cap rules and limits, even if it complied when the pension started.
  • A recipient spouse may not commute a pension resulting from the death of a member and retain the commutation amount within the superannuation system. However, a spouse may transfer the pension (ie roll it over) to another fund.  Because commutations of pensions resulting from the death of a person cannot be retained within the superannuation system, these pensions need to be specifically tracked and kept separate from other pensions.

The new law relating to death benefits paid as pensions

The value of a death benefit pension that is paid to a spouse will be credited to the spouse’s transfer balance account.  This value and timing depends upon whether or not the pension is a reversionary pension.

If the pension is not a reversionary pension:

  • The credit to the surviving spouse’s transfer balance account occurs when the pension to the spouse starts. This should be when the trustee resolves to pay the pension to the spouse.
  • The amount of the credit is the value of the deceased’s superannuation that is applied to pay the pension to the spouse at the time the pension to the spouse starts (generally when the trustee resolves to pay the pension to the spouse). So this value will include investment gains or losses that accrued to the deceased’s superannuation interest between the time the deceased member died and start of the pension to the spouse.

If the pension is a reversionary pension:

  • The credit to the surviving spouse’s transfer balance account occurs 12 months after the date of death of the deceased.
  • The amount of the credit is the value of the deceased’s superannuation that is applied to pay the pension to the spouse at the time of death. So this value will not include investment gains or losses that accrued to the deceased’s superannuation interest between the time the deceased died and 12 months later.

Example of the differences between reversionary and non-reversionary pensions

Consider the following example:

  • Fred was receiving a pension.
  • Fred died and his account balance at his death was $1.5m.
  • Six months later his account balance is $2.6m due to increase in value of assets.
  • His wife Susan has never received a superannuation pension.

If a non-reversionary pension is paid to Susan and the trustee resolves to pay it 6 months after Fred died:

  • The credit to Susan’s transfer balance account will be $2.6m, and will happen 6 months after Fred died.
  • Even though Fred was within his transfer balance cap and Susan had never received a superannuation pension, Susan must commute $1m of the pension.
  • Because it is a pension payable to Susan as a result of Fred’s death, she cannot keep the $1m in the superannuation system. It must be paid out as a lump sum.

If instead a reversionary pension is paid to Susan, then:

  • The credit to Susan’s transfer balance account will be $1.5m, and will happen 12 months after Fred died.
  • Unlike in the example where the pension in non-reversionary, Susan can keep all of Fred’s superannuation in the superannuation system. $1m does not need to be paid out as a lump sum.
  • In fact, even if the value of the pension account was, say, $3.6m 12 months after Fred died, Susan can still keep all the superannuation in the superannuation system, provided she retains the pension (ie Susan cannot commute part of it and keep the commutation amount in the superannuation system).

Will reversionary pensions always be better?

While it will depend upon the individual’s particular circumstance, it seems that reversionary pensions will often have more advantages than non-reversionary pensions.  Advantages in addition to the example above include:

  • Even if there is an excess amount that must be commuted and taken out of the superannuation system, there will be time to work out what will be the best to do with a reversionary pension, as there will not be a problem until 12 months after the death of the deceased. Any increase in the value over the 12 months won’t be taken into account when calculating whether the reversionary pensioner has exceeded their transfer balance cap.
  • A reversionary pension would not run the risk of breaching the requirements that a death benefit be paid as soon as practicable after the date of death of a member.5
  • As a reversionary pension is the one pension, there should be no problems with retaining the tax exemptions for the superannuation fund even if a minimum pension payment were not paid to the member prior to the member’s death.6

Non or limited commutable reversionary account based pensions

Some strategies using reversionary pensions have involved non or limited commutable account based pensions being paid from a SMSF to a spouse, and maximum pension payments being restricted (eg to the minimum payments to comply with the account based pension rules or some higher amount).  This strategy may have been used in blended families, where the goal was to pay a pension on the death of a member to the member’s second spouse, but restrictions were put in place so as much superannuation as possible could go to the member’s children on the death of the member’s second spouse.  Sometimes a commutation may only have been permitted with the consent of someone such as the member’s executors or children.

These pensions are still account based pensions, but have restrictions imposed upon them under the terms of the pension or trust deed.  They would not, for example, be ‘capped defined benefit income streams’ under the new law.

Any such pensions will now need to be reviewed, as on the death of the member there may be a significant problem (depending on the member’s superannuation balance and whether the second spouse is receiving their own pension).

How does all this apply where the spouse is also receiving a pension?

As mentioned above, both the deceased member’s superannuation to be paid to the deceased’s spouse as a pension, and the surviving spouse’s own pension, need to be taken into account in determining whether the surviving spouse has a problem.

The explanatory memorandum that accompanied the Bill that introduced the new law has some good discussion and examples relating to this.7  However, for the purpose of this article, we will take our initial examples relating to Fred, and this time assume that his wife Susan dies with an account balance of $2m.  How much of that $2m can Fred receive as a pension (we will ignore the differences between reversionary and non-reversionary pensions)?

Example 1 – Fred’s pension account has grown to $2m

Fred starts a pension after 30 June 2017 with an account balance of $1.6m.  His transfer balance cap is $1.6m and the credit to his transfer balance account is $1.6m.  The credit does not exceed his transfer balance cap.  So Fred will comply with the new law.

Say Fred’s pension account becomes $2m with growth and Susan’s account balance that will be taken into account for determining what Fred can take as a pension from Susan’s superannuation is $2m.

Fred has already used up his pension transfer cap.  What can he do?  Fred’s choices are:

  • Take Susan’s superannuation as a lump sum. There will then not be a credit to Fred’s transfer balance account, and he can keep his pension going.  However, Susan’s superannuation must then be taken out of the superannuation system.
  • Take all of Susan’s superannuation as a pension. This will result in a credit to his transfer balance account of $2m.  This is a problem.  However, Fred can commute his pension for $2m, and there will be a debit to his transfer balance account of $2m.  His transfer balance account will then be $1.6m, so no problem.  Also, as the pension Fred is commuting was not a pension payable on anyone else’s death, he can retain that commutation amount in the superannuation system (ie in accumulation mode).  So he can keep his $2m, plus Susan’s $2m, in the superannuation system and may receive $2m of this as a pension.

Example 2 – Fred’s pension account has dropped to $600,000

Fred starts a pension after 30 June 2017 with an account balance of $1.6m.  His transfer balance cap is $1.6m and the credit to his transfer balance account is $1.6m.  The credit does not exceed his transfer balance cap.  So Fred will comply with the new law.

Say Fred’s pension account drops to $600,000 with falls in value of assets and pension payments, and Susan’s account balance that will be taken into account for determining what Fred can take as a pension from Susan’s superannuation is $2m.

Fred has already used up his pension transfer cap.  What can he do?  Fred’s choices are:

  • Take Susan’s superannuation as a lump sum. There will then not be a credit to Fred’s transfer balance account, and he can keep his pension going.  However, Susan’s superannuation must then be taken out of the superannuation system.   This is the same as in the above example.
  • Try to take all of Susan’s superannuation as a pension. This will result in a credit to his transfer balance account of $2m.  Unlike Example 1, Fred can only commute his pension for $600,000, and if he did that there will be a debit to his transfer balance account of only $600,000.  His transfer balance account will then be $1.6m less $600,000 plus $2m, ie $3m.  This is an excess of $1.4m above his transfer balance cap.
  • Take $600,000 of Susan’s superannuation as a pension and the balance ($1.4m) as a lump sum. This will result in a credit to his transfer balance account of $600,000.  This is a problem.  However, Fred can commute his pension for $600,000, and there will be a debit to his transfer balance account of $600,000.  His transfer balance account will then be $1.6m, so no problem.  Also, as the pension Fred is commuting was not a pension payable on anyone else’s death, he can retain that commutation amount in the superannuation system (ie in accumulation mode).  So he can keep his $600,000, plus $600,000 of Susan’s $2m, in the superannuation system and may receive $600,000 of this as a pension.  The balance of Susan’s superannuation of $1.4m must be taken out of the superannuation system.

Conclusion

It seems to us that the impact of the new law needs to be taken into account in reviewing estate planning goals, particularly if there is significant superannuation and it is desired to keep as much superannuation in the superannuation system as possible on the first spouse to die.

Reversionary pensions could often have more benefits than non-reversionary pensions.  However, any arrangements currently involving SMSFs paying non or limited commutable account based reversionary pensions should be carefully reviewed.

With more spouse death benefits needing to be paid out of the superannuation system in the future, alternative strategies such as testamentary trusts need to be considered.  Of course, there will be tax benefits in a lump sum death benefit going to a spouse, but then the superannuation could not be part of a testamentary trust. This could mean that it will be more important under the new law to take superannuation out prior to death where it will be tax free, especially as an excess is going to be ‘kicked out’ of the superannuation system after death anyway.  The payment can then be the source of capital for a testamentary trust.

But most of us will not know when we will die, and taking superannuation out too early can have its own taxation disadvantages.

*This article was first published by CCH Tax Week on 10 March 2017.

For further information please contact:

Philip de Haan | Partner | +61 2 9020 5703 | pdehaan@tglaw.com.au
Aimee Riley | Lawyer | +61 2 8248 3451 | ariley@tglaw.com.au

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1 Indexation rules also apply, but are not discussed in this article.
2 Similar rules apply to pensions that are in place then.
3 See paragraph 3.107 of the explanatory memorandum that accompanied the Bill that introduced the new law for discussion and an example relating to negative balances in a transfer balance account.
4 See Superannuation Industry (Supervision) Regulations 1994 (SISR) regulation 6.21.
5 Also relevant to the tax exemptions for the fund.
6 In practice the Commissioner does not require the minimum pension payment for a non-reversionary pension to be paid to the deceased in the year of death (Australian Taxation Office ‘Funds – starting and stopping a pension’ https://www.ato.gov.au/super/self-managed-super-funds/in-detail/smsf-resources/smsf-technical/funds–starting-and-stopping-a-pension/).
7 Paragraphs 3.73 to 3.98.