Commuting an SMSF account-based pension

There are many circumstances under which an SMSF retiree might consider commuting all or part of their allocated pension. Concerns about falling asset values, the need for an unexpected cash injection for a large purchase or to assist a dependent family member are just a few.

Essentially, commuting a pension just means to stop it and transfer it to a lump sum but there are particular processes SMSF trustees need to follow in order to do this.

How does it work?

This strategy involves stopping regular pension payments and shifting all funds back into an accumulation account within the SMSF. To do this, a member needs to make a request in writing to the fund for their entitlements to future super income stream benefits to be commuted. If the member wishes, the pension balance can be paid out but it can also be kept in the fund and added to the member’s accumulation balance.

If the lump sum is made by an in-specie transfer of assets to the member, it is important that this is allowed in the SMSF’s trust deed and other governing rules. If it isn’t, the trust deed may need amending to allow the in-specie transfer.

There may also be capital gains tax implications for the SMSF if a capital gain is made on an in-specie transfer of the investment to the member. There will be a capital gain if the value of the asset at the time of transfer to the member is greater than the value at which it was acquired. Where the pension balance is transferred to the member’s accumulation account, there is no capital gain as it occurs only if the fund sells or disposes of the investment.

If the asset was owned for less than a year and subsequently sold after the transfer to the accumulation account, the full capital gain must be added to the fund’s taxable income for the year. If it has been owned for more than a year, then a one-third discount applies and only two thirds of the taxable capital gain will be taxed in the fund.

What do you need to know?

The important thing to remember about this strategy is that you are still legally required to pay yourself the pro-rated minimum annual pension for the year if you want the earnings on the funds supporting the pension prior to commutation to be considered exempt current pension income (ECPI) for tax purposes.

The ATO also stipulates that a payment resulting from a full commutation cannot count towards the required minimum annual pension amount.

The pro-rata minimum payment amount that must be paid prior to commutation is calculated using the formula:

Pro rata minimum payment amount = minimum annual payment amount × days from the commencement day to the day pension commuted ÷ 365 (or 366 in a leap year)

The minimum percentage factors are shown in the table below.

Source: SIS Act

You also need to complete a transfer balance account report and lodge it with the Australian Taxation Office.

What are the pitfalls?