Being pension wise

Enjoying the significant advantages of having a pension interest inside an SMSF involves adherence to many rules and regulations. Accurium head of SMSF education Mark Ellem and senior SMSF educator Anthony Cullen examine the requirements trustees must satisfy.

SMSFs provide individuals with greater control over their retirement savings, allowing them to tailor investment strategies to meet their long-term financial goals. However, with this flexibility comes significant responsibility, such as ensuring compliance with strict pension rules set out by the Superannuation Industry (Supervision) (SIS) Regulations and regulated by the ATO.

When it comes to SMSF pensions, trustees and members must navigate various requirements, including pension commencement, minimum payments, taxation, transfer balance caps and reporting obligations. Failing to adhere to these rules can lead to compliance breaches, loss of tax concessions and potential financial penalties. This article explores the key aspects of SMSF pensions, highlighting what to look out for and common pitfalls to avoid.

Understanding pension types

SMSF pensions fall into two primary categories: accountbased pensions (ABP) and transition-to-retirement income streams (TRIS).

• ABP: These pensions require minimum annual withdrawals based on the recipient’s age and account balance. The capital supporting the pension remains invested and subject to market fluctuations. These pensions are in the retirement phase and qualify for tax concessions, including exempt current pension income (ECPI).

• TRIS: A TRIS allows a member to access their super while still working, provided they have reached their preservation age (now age 60). However, since 1 July 2017, a TRIS is not a retirement-phase income stream and not eligible for ECPI unless the member has met a condition of release with a nil cashing restriction, such as reaching age 65 or retiring permanently. Additionally, withdrawals from a TRIS are capped at 10 per cent of the account balance per financial year.

While defined benefit pensions and market-linked pensions still exist within some SMSFs, they are largely legacy products and cannot be newly established. These pensions have complex rules and reporting obligations, and recent changes allow for a five-year exit measure to unwind some legacy pensions.

Understanding the differences between these pension types is crucial for ensuring compliance with regulations and optimising retirement outcomes.

Key considerations at commencement

1. The eligibility criteria

To commence a pension, a member must have met a condition of release, such as:

• retirement after reaching preservation age,

• reaching age 65, regardless of work status, and

• permanent incapacity or terminal illness.

Members must also check the preservation status of their superannuation benefits before commencing a pension. Preserved benefits cannot be accessed unless the member satisfies a condition of release or where the condition of release is ‘attaining preservation age’, that is, the TRIS condition of release.

2. The trust deed

The trust deed is the governing document of an SMSF. Before commencing a pension, trustees should ensure that:

• the deed allows for the payment of pensions in accordance with the superannuation rules. SIS Regulation 1.06(1) sets out when a benefit is a pension and requires certain rules to be included in the governing rules of the fund, that is, either the trust deed or the pension documents, and

• where the trust deed of an SMSF paying legacy pensions is updated that the amendment accommodates them, that is, does not remove the ability of the fund to continue to pay them to the member(s).

3. Timing and valuation

The valuation of the pension commencement balance is critical for transfer balance cap reporting. Trustees should ensure:

• accurate and timely valuation of fund assets to avoid administrative complications and reporting discrepancies,

• all capital intended to be included in the commencement value of the pension has been received by the fund, and

• where a member intends to claim a tax deduction for a personal contribution to be included in the commencement value of the pension that the relevant notice has been provided and trustee acknowledgement given.

4. Sufficient liquidity

Once a pension starts, the SMSF must ensure it has enough liquid assets to meet ongoing pension payments. Trustees should review the fund’s investment strategy to confirm:

• cash-flow projections can sustain pension withdrawals,

• investments are appropriately diversified, and

• the strategy is updated to reflect the fund’s new status.

Common mistakes and pitfalls

1. Failure to meet minimum pension

Each year, an SMSF must pay at least the minimum pension amount calculated as:

The percentage is based on the member’s age, with older members required to withdraw a larger proportion.

Failure to meet the minimum pension payment results in:

• the pension ceasing for tax purposes, meaning the fund cannot claim ECPI,

• payments being treated as lump sum withdrawals, which may be taxable. This is of particular concern for a TRIS as this will likely result in a breach of the preservation rules and may result in the amount(s) paid being fully assessable, notwithstanding the member is at least age 60, and

• a transfer balance account (TBA) adjustment, potentially affecting the member’s transfer balance cap (TBC).

The update to Taxation Ruling (TR) 2013/5 in June 2024 means the period that the fund cannot claim ECPI is likely to extend beyond the financial year in which the minimum pension failed to be paid. Further, there are likely to be implications for the tax components of the member’s benefits, as well as for their TBA.

2. Inaccurate TBC event reporting

Since 1 July 2017, SMSF pensions have been subject to the TBC, which limits the amount an individual can shift into retirement-phase pensions. Each pension commencement, commutation or modification must be reported to the ATO within 28 days after the end of the quarter in which the TBA event occurred.

Common reporting mistakes include:

• failing to report pension commencements or commutations,

• failing to report a TBA event by the due date,

• confusing the 12-month deferral to the TBA credit for a reversionary pension and the due date for reporting the TBA event, and

• not correcting a previously reported TBA event by cancelling it and submitting a new one.

While the ATO will maintain the TBA transactions and TBC for the member, it would be prudent for the member’s accountant or adviser to have their own record for their TBA and TBC-related information as a source of truth. This can then be compared to the ATO records with any discrepancies investigated and corrected.

3. Incorrect commutation procedure

A commutation occurs when a member converts their pension into a lump sum. While full and partial commutations are permitted, trustees must ensure:

• partial commutations do not count toward the minimum pension payment,

• minimum pension payments are made before full commutations, and

• TBA event reporting has been accurate and complete to ensure any entitlement to the indexation of the general TBC.

Incorrectly reported commutations may lead to tax penalties and time spent to correct the reporting errors.

The role of ECPI

ECPI allows SMSFs to reduce their taxable income on assets supporting retirement-phase pensions. However, trustees must ensure:

• the correct method is used, either the segregated or proportionate. This will require determination of whether the SMSF has disregarded small fund assets for a financial year,

• an actuarial certificate is obtained where the proportionate method is used, and

• ECPI is not claimed incorrectly, particularly if the pension has ceased. Also, trustees need to ensure ECPI cannot be claimed against fund assessable income that has been determined as non-arm’s-length income.

Given the size of the total claim for ECPI by SMSFs, this is an obvious target area for the ATO and it would be prudent for practitioners to run self-checks or peer reviews to ensure their understanding and approach is correct. In addition to claiming ECPI when not entitled, or over-claiming, funds failing to claim ECPI correctly may pay unnecessary tax. This could come about by incorrectly apportioning fund deductions, that is, under-claiming. Practitioners need to have a good understanding of how ECPI affects fund deductions and how their SMSF administration platform deals with them.

Pensions and death benefits

When an SMSF member dies, their pension ceases unless it is reversionary. The fund must then comply with SIS Regulation 6.21, requiring benefits to be cashed as soon as practicable.

Reversionary versus non-reversionary

• Reversionary pensions automatically transfer to a nominated beneficiary (for example, a spouse). The transfer balance credit occurs 12 months after death, preserving the member’s TBC space until this time. There is no requirement to commute the reversioner’s own pension on date of death, even where the TBA credit will cause the reversionary recipient to exceed their TBC. Commuting early could cost the SMSF valuable ECPI, particularly if fund assets are sold in the 12 months after death.

• Non-reversionary pensions must be paid out as a lump sum or used to start a new death benefit pension. However, it will be subject to the reversionary pensioner’s TBC and they must be an eligible recipient of a death benefit income stream. Generally a deceased member’s super cannot be cashed to an adult child, notwithstanding they may qualify as a death benefits dependant for tax.

Impact on ECPI

While a non-reversionary pension ceases on the date of death, ECPI can continue to be claimed in respect of that interest provided it is cashed as soon as practicable. There is also no requirement to pay a minimum pension in the financial year of death. This also applies to any subsequent financial year, but, again, provided it is paid as soon as practicable. Reversionary pensions, however, continue uninterrupted, preserving ECPI benefits. The death of the primary pensioner does not affect the calculation of the required minimum pension in the financial year of death. It is determined based on the account balance and age of the pension recipient on 1 July.

The legacy pension amnesty

Since 7 December 2024, SMSF members with legacy pensions, such as lifetime and life expectancy complying pensions and marketlinked pensions, have been given a five-year window in which to fully commute these income streams. This allows:

• greater flexibility in estate planning,

• the ability to consolidate superannuation assets, and

• potential tax efficiencies, depending on how the commutation is structured.

However, trustees must carefully assess the tax implications before exiting a legacy pension. Social security entitlements may also be a factor to consider.

Best pension management practices

To maintain compliance and optimise retirement outcomes, SMSF trustees should:

• ensure pensions meet all SIS and tax requirements,

• review the trust deed and update it if necessary,

• pay the minimum pension amounts each year. With the update to TR 2013/5 and the potential adverse consequences of failing to pay the minimum pension, a review of practice procedures and client education is a must,

• accurately report all TBA transactions,

• regularly review the investment strategy to ensure liquidity,

• consider tax implications, especially regarding ECPI and commutations, and

• seek professional advice for complex pension strategies.

By staying informed and avoiding common pitfalls, SMSF trustees can ensure their retirement income streams remain compliant, tax-efficient and sustainable. SMSF advisers and service providers can greatly assist their clients to avoid the pitfalls and enjoy a compliant retirement.