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How to commence a pension with non-concessional contributions

Accurium  |  06 Mar 2017Text size  Decrease  Increase  |  

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Commencing a pension is one of the most important tasks when running a self-managed super fund (SMSF). An SMSF with a correctly established pension interest may be eligible to claim tax-exempt income, a significant tax concession to the fund.

However, there are some common mistakes trustees make when commencing a pension using only part of a member's accumulation balance.

Case study: Commencing a pension with a specific member contribution

John and Jenny have an SMSF. At 1 July 2016 both members had an opening accumulation balance of $150,000 from previous concessional contributions and income.

Between 1 July 2016 and 31 December 2016, the fund received $10,000 in concessional contributions for each member. John also made a personal non-concessional contribution of $180,000 on 4 January.

On 9 January, John retired and decided to convert $180,000 to an account-based pension and leave his remaining balance in accumulation phase.

On 9 January, John's accumulation interest was the sum of:

• $150,000 opening accumulation balance

• $10,000 concessional contributions

• $180,000 non-concessional contribution

John's intention was to start his pension using only the $180,000 non-concessional contribution made to the fund on 4 January.

The SMSF had received the contribution and so John assumed he could complete trustee minutes to commence an account-based pension with $180,000 on 9 January and for that pension to be made up of a 100 per cent tax-free component since the contribution was non-concessional.

However, John's assumption would be incorrect. There are two key additional steps John must consider:

• Fund assets must be revalued at market value

• The tax-free and taxable components of the accumulation interest must be calculated

Revaluing fund assets in order to calculate the tax components

A member can have only one accumulation interest and any contribution to the SMSF will add to that accumulation interest.

The tax-free and taxable component of this accumulation interest is always changing based on contributions and earnings received.

It does not matter if a member wishes to commence a pension using their full accumulation balance or only a specific proportion of their accumulation balance--the accumulation interest must be revalued in order to calculate the tax components.

This is because the tax components of the new pension interest must be the same as the tax components of the member's accumulation interest just before the commencement of the pension.

Even if a pension is commenced on the same date a contribution is received into the fund, the tax components need to be recalculated, unless the member had no existing accumulation balance at that date.

The ATO state in their guide to starting and stopping a pension: "Once a super income stream commences, you're required to treat the amount supporting the income stream as a separate interest in accordance with the income tax laws."

"The value of the separate interest, including the amount of its tax-free and taxable components, must be determined when the super income stream commences.

"The proportions of the tax components of this separate interest will be the same as the proportions for the tax components of the member's original non-pension interest just prior to the commencement of the income stream.

"This prevents members from choosing which tax components they wish to start a super income stream with."

Information on revaluation requirements can also be found in the ATO's valuation guidelines for SMSFs.

Case study revisited: Calculating the tax components of John's pension

John cannot choose to set the tax components of his pension equal to the 100 per cent tax-free component of the non-concessional contribution.

The tax components of the new pension must be based on the tax components of his total accumulation interest just prior to commencement.

The market value of John's accumulation balance as at 9 January was $342,000, made up of:

• $150,000 opening accumulation balance

• $10,000 concessional contributions

• $180,000 non-concessional contribution

• $2,000 earnings

John's accumulation interest prior to him making the non-concessional contribution was made up solely of concessional contributions and investment earnings. As such, his accumulation interest had a $0 tax-free component.

At 9 January, after making the non-concessional contribution, his tax-free component increased to $180,000. The tax-free proportion of his accumulation interest is therefore:

= $180,000/$342,000

= 52.63 per cent tax-free component

When documenting the details of his new pension the tax-free and taxable components will be based on this proportion.

• Commencement value $180,000

• Tax-free component 52.63 per cent

The taxable component is therefore 47.37 per cent. The tax-free and the taxable components are fixed and will not change over the life of the pension.

Any income allocated to the pension account will not affect the tax-free proportion and pension payments made from this account will be made up of the same tax-free and taxable components.

Keeping track of tax components of pensions

Calculation of the tax components must be done each time a new pension is commenced. It is possible for a member to have multiple pension interests, each with different tax-free and taxable components.

Getting the tax components right is important when paying tax on payments under age 60, and if benefits are paid to non-dependants upon the death of the pensioner.

This calculation is best done upfront as part of setting the terms of the pension since it can be hard to work out many years down the track.

More from Morningstar

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