Deciding Which Pension to Commute When There Are Multiple Pensions and the Total Super Balance Is Over $1.6 Million
Many of our clients will have commenced multiple pensions within their self-managed superannuation funds. This may have been done to quarantine tax-free components, or simply to commence pensions after contributions had been made.
Where a member has multiple pensions, and the total of these pensions will be over the Transfer Balance Cap when a member satisfies a condition of release, a decision will need to be made regarding which pension is the best one to commute to bring the total pension balance within the new limit.
You may also see this situation where a client already has a pension (or multiple pensions) and also has an accumulation balance, where a client has multiple transition to retirement pensions (not in retirement phase), or where a client would make a contribution (say a Small Business CGT contribution, or downsizer contribution) – and be faced with a decision over which pension to keep – a bit like choosing your favourite child!
As a general rule of thumb, it has been suggested that when choosing between one or more pensions to commute and roll back into accumulation phase, the pension with the higher proportion of taxable component should generally be commuted, provided that the anticipated pension payments from all remaining pensions are lower than the fund’s overall growth.
This is due to the fact that the only way to increase a tax-free component is either to make non-concessional contributions, or via the earnings in a pension. As an example, say your client had a pension of $1,000,000, which was 50% tax-free and 50% taxable. The fund received $50,000 of earnings. In the pension account, the tax-free component would increase by $25,000 and the taxable component would increase by $25,000.
In comparison, if the $1,000,000 with the same tax-free and taxable components was in accumulation phase, then the entire $50,000 of earnings would be allocated to the taxable component.
Over the long term, this has quite a significant impact on the growth of the accounts and ultimately, the amount of tax paid by any non-dependents receiving a death benefit, such as adult children.
Whilst the general rule of thumb is to leave the higher tax-free pension, consideration needs to be given as to the yield in the fund in comparison to the minimum pension requirement. If the earnings are less than the minimum pension requirement, it may well be worth commuting the tax-free pension. It would be of benefit to provide an analysis of this to your clients, taking into consideration different potential earning rates.
John is 60 years of age and currently has two account-based pensions in place, the first pension has a balance of $800,000 and is 100% tax-free. The second pension also has a balance of $800,000 and is 20% tax-free.
John makes a small business CGT contribution of $500,000 on 31 January 2020.
Should he look to commence a pension with this contribution, John is going to be over his Transfer Balance Cap by $500,000, and therefore needs to make a decision as to which pension he commutes. His alternatives are as follows:
- Commute the pension that is 100% tax-free;
- Commute the pension that is 20% tax-free; or
- Commute both pensions and re-commence a new pension for $1,600,000 (which will mean the new pension is approximately 70% tax-free).
As John is 60 years of age, the minimum pension requirement for the next 5 years is 4%. This will then increase to 5% until age 74, 6% to age 79, 7% to age 84, etc.
The following graph assists in making a decision as to deciding whether to keep the tax-free pension in the pension phase, depending on whether the fund’s earnings rate is a 5% (bottom line in graph), 6% (middle line in graph) or 7% (top line in graph).
At a 5% earning rate, when John turns 79 years of age, it is no longer worthwhile for him to have the tax-free pension in pension phase. This is compared to if the fund earned 7%, it is worthwhile for John, well into his 90s.
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Disclaimer: The information contained is general in nature. Professional advice should be sought before acting on any aspect on this page.