SMSFs need to carefully consider the estate planning ramifications before commencing a pension, or their beneficiaries might face serious tax consequences, explains Nicholas Ali.
Prior to commencing an income stream from a self-managed super fund (SMSF), it is important to consider the estate planning ramifications. If not, substantial unnecessary tax may be paid by beneficiaries.
Let’s look at Ron, a widower, who is 64, recently retired and looking to commence a pension in the 2012-13 financial year.
Ron has $500,000 in a maturing term deposit and $100,000 in cash in his SMSF (all a taxable component) and he looks to transfer the property from which he runs his business into his fund.
This property is worth $700,000 (with a $500,000 capital gain) and Ron uses the 15-year exemption to eliminate capital gains tax (CGT) and exclude the contribution from the non-concessional cap.
The property is contributed prior to 30 June 2012.
Ron commences a pension on 1 July 2012 with the $1.3 million in his fund. Once an income stream commences the components in the fund are crystallised; so $600,000 will be a taxable component (46.15 per cent) and $700,000 will be a tax-free component (53.85 per cent).
As the fund grows (or reduces) over time, the two components will move proportionately.
Unfortunately Ron passes away suddenly on 1 July 2014. Let’s assume the fund now consists of shares worth $500,000, cash of $25,000 and the business real property, which has increased to $1,000,000. Furthermore let’s assume the shares have a cost base of $400,000.
Ron leaves his superannuation to his only son Jeremy, who is 40 years old and a non-dependant. As such, Jeremy can only take Ron’s superannuation in the form of a death benefit lump sum.
As the fund is worth $1,525,000 and the components were crystallised at the commencement of the pension, the components are $703,788 taxable (46.15 per cent) and $821,152 tax-free (53.85 per cent).
The taxable component will be subject to 15 per cent lump sum tax (plus Medicare levy) and the tax-free component will be received by Jeremy tax free.
Therefore lump sum tax and Medicare Levy on the taxable component will be $116,125 ($703,788 x 16.5 per cent).
In addition to this, CGT will be payable by the fund as the pension exemption ceases when Ron dies.
This is confirmed by the Australian Taxation Office (ATO) in ATO ID 2004/688 and Draft Ruling 2011/D3.
Therefore the fund is in accumulation mode when it makes the death benefit payment to Jeremy. The unrealised capital gain on the fund’s assets is $300,000 for the property and $100,000 for the shares.
Allowing for the one-third discount in superannuation, this leads to CGT of $40,000 (ie, $400,000 x 66.66 per cent x 15 per cent = $40,000).
By taking greater care in the initial set-up of his income stream, Ron could have ensured the tax on his superannuation was substantially reduced.
To achieve this Ron could utilise a re-contribution strategy; taking $150,000 as a tax-free lump sum prior to 30 June 2012 and re-contributing this as a non-concessional contribution to commence a pension.
Then in early 2012-13 Ron could take another tax-free lump sum of $450,000 and re-contribute this back to superannuation using the bring-forward rule (assuming Ron is less than 65 on the 1st of July).
Ron’s benefit in the fund would now all be a tax-free component, being the superannuation interest used to commence the pension of $150,000, the $450,000 re-contributed as a non-concessional contribution using the bring-forward rule and the in-specie contribution of the property worth $700,000 using the CGT 15-year exemption (this is considered a non-concessional component but does not count against the non-concessional cap), assuming no earnings in the meantime.
Ron could then commence a second pension with the remaining monies in the fund (ie, the $450,000 non-concessional using the bring-forward and the $700,000 using the CGT 15-year exemption).
Again, as this second pension is a separate superannuation interest, the components are crystallised; meaning Ron now has two pensions consisting solely of tax-free components.
As there is no taxable component, if Ron was to pass away, Jeremy would be spared the $116,125 lump sum tax payable.
The CGT may also be able to be eliminated with the use of an anti-detriment payment. An anti-detriment payment is effectively a refund of the 15 per cent contributions tax paid by the deceased during the accumulation phase.
It is a lump sum amount that is paid in addition to the account balance of the deceased member.
It is only payable where the death benefit is being paid out as a lump sum to an eligible dependant such as a spouse, former spouse or child of the deceased member (as defined in section 295-485(1)(a) of the Income Tax Assessment Act 1997).
It is usually paid from a fund reserve that, in most SMSFs, is created via fund earnings.
The anti-detriment payment also creates a deduction in the fund, which can be used to offset assessable income; such as the CGT in the case study above.
However it is important to remember in this instance an amount allocated from a reserve will be considered a concessional contribution and recorded against the deceased member’s concessional contributions cap.
The exception is where the amount allocated from a reserve is allocated to every member in a ‘fair and reasonable manner’ and is less than 5 per cent of the value of the member’s interest in the fund at the time of allocation.
Finally, there has been some conjecture that such a recontribution strategy as outlined above invokes the Part 4a anti-avoidance provisions of the Tax Act.
However, the ATO has confirmed it is unlikely a recontribution strategy will invoke Part IVA of the Tax Act if the recipient is able to receive tax-free lump sums from superannuation and re-contribute as non-concessional contributions (as in Ron’s case) due to the fact it is impossible to determine what the future holds.
For example, Jeremy may pre-decease Ron, or Ron may re-marry and alter his death benefit wishes.
The ATO in the National Tax Liaison Group Superannuation Sub-Committee Technical Minutes of September 2010 and March 2011 states it is difficult to identify a tax benefit.
Specialist financial advice should be sought prior to commencing an income stream from an SMSF to ensure all planning aspects, including estate planning, are considered.