What happens to your Super Pension when you die? Does your super fund pay tax on income and capital gains before it pays a lump sum to your dependants?

How can a SMSF avoid paying CGT upon death of a pension member?

The only way assets paying a pension can continue to be paying an income stream is when those assets continue to be in "pension phase", this is possible when at the time of setting up the pension documents, the income stream is designed in such a way that it is reverted to a death benefits dependant, which means that the income stream never stops. After the death of the pensioner, income stream is paid to the death benefit dependant.

Note that adult children over the age of 25 are not death benefits dependants and the pension cannot be reverted to them. This could be a problem where one spouse is alive with adult children or in case of joint death, where both spouses die together and there are no death benefits dependants where the pension can revert (no secondary beneficiary).

If the pension does not revert, then all assets are sold to pay a lump sum to the dependants, CGT by the fund has to be paid before the superannuation interest of the deceased member can be paid to the dependants.

For example......

Smith Family Super Fund is a SMSF. The SMSF purchases ABC shares with all the super money for $100,000 @ $10 for each share in 2000 when the only member John Smith is in accumulation phase - on 1^st July 2009, John turns 57 and retires and commences an account based pension (income stream) with 100% balance of his superannuation interest. At that point of time ABC shares are $40. Note that no CGT is paid when the John moves from accumulation phase to pension phase

On 1^st January 2010 John smith dies. At this point of time ABC shares are $55. Since there is a binding death nomination is in place and the pension is not a reversionary pension, the balance of the fund after tax has to be paid out to his wife as a lump sum.

The SMSF must sell all the 10,000 shares for $55 each - this will result in a capital gain of $45 per share or $450,000. The tax on this gain is 10% or $45,000 as the asset was held for longer than one year. The trustee of the fund must first pay this tax from the sale proceeds of $550,000 and then pay the balance of $505,000 to his wife as a lump sum. Since his wife is a tax death benefit dependant, on receipt all the amount received is tax free to her.

Can the trustee commence a pension for the dependant instead of paying a lump sum as per the death nomination form?

The answer is yes, however, the trustee still has to pay the tax and then commence a pension for the dependant with the balance of $505,000 as in the above example. Which means, instead of paying a lump sum, the trustee can, upon request from John wife, commence a pension for her instead of paying a lump sum.

However, if the pension was set by John Smith as a reversionary pension on 1^st July 2009, the trustee would not have to do anything more than to revert the pension to John's wife upon John's death.

Can a non tax death dependant be a reversionary beneficiary?

No. If the dependant is not a tax dependant (who is not a tax dependant click here for our previous article), then the trustee has no choice and must pay a lump sum to the non tax death benefit dependant.

Further, tax may be paid @ 15% plus medicare levy by non-tax dependant on receipt of death benefit payment, if the death benefit is from a taxable component - for further details read my previous article for details.

Can this Capital gain tax paid by the SMSF upon the death of the member be saved?

Yes, if the member at the time of commencing the income stream (pension), determines that on his death, the pension will revert to his tax dependant, then there is no need to sell the assets of the fund and pay any tax to pay a lump or to commence another pension for the tax dependant by the trustee. Hence, drafting correct pension documents is very important.

There is no formal guidelines by the ATO on how account based pensions should be commenced in a self managed super fund. Many advisors just do minutes to approve the request of the intending member that he or she would like to commence a pension and no formal "pension agreement" is drawn up. This is incorrect, because all pensions must meet the requirements of SISR 1.06 and commutation of each pension must meet the requirements of SISR 1.07.

Proper pension agreement between the intending pensioner and the trustee must be executed to decide all the pension conditions which the trustee and the pensioner have to follow after the pension commencement date.

What are pension documents?

When a member of a self managed super fund decides not to take a lump sum on his superannuation interest after reaching preservation age, but decides to convert his accumulation superannuation interest into a pension account and draw income stream from this pension account, pension documents are drawn to give effect to this income stream.

The procedure to convert his superannuation interest to a pension account is a step by step process and involves preparing all the below pension documents;

Application by member to the trustees requesting his account to be converted to pension phase;
The trustee will then accept the member's request and then check if the member has reached preservation his age and check if the trust deed allows the pension which the member is requesting. Please note that from 21^st September 2007 only account based pensions can be paid from a self managed superannuation fund - which means that if your trust deed is older, the trustee cannot pay any pensions to the member. A simple solution to this problem is to update the SMSF trust deed. (click here to update your trust deed)
The trustee must hand over a product disclosure statement (PDS) to the member as the pension is a financial product as per Corporations Law and the member should be aware of all rules surrounding his income stream.
Trustee mut hand over a schedule of payments to the intending pensioner. This schedule must disclose all pension conditions and clearly show to the member, the effect of converting his superannuation interest to pension phase. The schedule of payments must also show to the member, what income stream he can expect from the fund and what taxes will apply to the payments, if any. If the pension is a transition to retirement income pension, then it must also disclose the maximum amount which can be withdrawn by the member.
After reading the PDS and the schedule of payments, the member must request the trustee to draw up the pension agreement based on his understanding of the PDS and the pension conditions of SIS Act and Regulations.
Once the pension agreement is drawn up and executed, the member is able to commence an income stream.
After the pension agreement is executed, the trustee's minute the action of the member and commence paying a pension to the member as per pension agreement. From thereon the trustee and member must follow all the pension agreement terms and conditions.

How to commence an account based pension

What issues must the pension agreement must cover?

The pension agreement must satisfy provisions of various legislations and requirements, such as:-

1) SIS Act and SIS Regulations

2) Income Tax Act to claim exempt current pension income

3) Corporations Act, considering that a pension is a financial product

4) Annual audit report issued by the auditor to the trustee

SIS Act and Regulations

Specifically any pension agreement must have the following issues covered:

What type of pension is being paid to the member (SISR 1.06 (9A) - simple pensions)
Pension payment must be made at least once in a year
Must be the minimum amount as stipulated in SISR Schedule 7 clause 1 (minimum 4% etc)
The pensioner cannot withdraw more than the account balance of the superannuation interest - maximum can be 100% in an account based pension. (If you were drawing a pension on 20^th September 2007, then most likely you are drawing the older style Allocated Pension. These pensions are very similar to the new account based pensions, but they have a higher minimum amount which must be withdrawn each year in comparison to the new account based pension and have a maximum amount which can be withdrawn each year. Whereas if the pension is an account based pension, you can withdraw 100% of the balance in any one year, which means if you want to withdraw more than the maximum amount of the allocated pension, you have no choice but to convert your allocated pension to the new account based pension - provided the conversion is allowed by your trust deed).Click here to convert allocated pension to account based pension.
The payment of pension is paid through out the life of the pensioner and may revert to death benefit dependant beneficiary.
The pension has to be paid until there is no more balance in the superannuation interest.

· If the pension is commuted, then the commutation amount cannot exceed the benefit that was payable immediately before the commutation.

· The pension is transferable to another person only on the death of the beneficiary (primary or reversionary, as the case may be).

· The capital value of the pension and the income from it cannot be used as a security for a borrowing.

· Pension can not be reverted to any non-death benefit dependant beneficiary after 1 July 2007, which means that the pension cannot be transferred or paid to a person who would not be eligible to be paid a benefit in the form of a pension under sub regulation 6.21 (2A) or (2B).

If your pension agreement does not have the above conditions, then basically, your pension agreement is not properly drawn up and if the tax office questions your claim of exempt pension income in the income tax return you have a weak case. This means, that the tax office could argue that the member is either not on pension as the pension agreement does not exist or is not properly executed.

Income Tax Act

The auditor of the fund, in his financial audit has to insure that the accounts represent correctly and the tax worked out in the in accounts prepared by the trustees is correct.

Usually, this task is simple if all the members are in accumulation phase or in pension phase, the problem arrises when some of the members of the fund are on pension while others are in accumulation phase. Also sometimes, it is possible that the same member could be on transition to retirement pension and has a pension account while contributing to his accumulation account.

Incomes from assets which are paying a pension are exempted from paying income tax, SMSF paying a benefit are not automatically entitled to the exemption - it must meet certain other conditions.

To claim the Exempt current pension Income (ECPI) exemption in the SMSF annual return, there are steps you must take prior to commencing the payment of the super income stream benefit, such as ensuring that all of the SMSF's assets are re-valued to their current market value.

There are two methods for working out the amount of ECPI you can claim - the:

segregated method - that is the assets paying a pension are kept separate from those assets which are not paying a pension.
unsegregated method - that all the assets of the fund are mixed up that it is difficult to distinguish which particular asset is being used to pay an income stream

Actuarial certificate

If you want to claim a tax exemption on the SMSF's income whilst paying a super income stream benefit when the assets of the fund are unsegregated, you need an actuarial certificate as described in Sec 295 - 390 of ITAA 2007.

Actuarial certificate determines the percentage of income which can be attributed to pension paying assets if you use the unsegregated method. This percentage will also help you to calculate the amount of ECPI you can claim in your income tax return.

If all the members of the SMSF are on pension and there is no accumulation account, there is no need of an actuarial certificate.

If you have a reserving policy in the SMSF to make any future anti-detriment payment to create a loss in the fund, any reserves held by the SMSF cannot claim ECPI and always remain in accumulation phase whilst not allocated to any one member, an actuarial certificate will be required each year even if all the members are in pension phase when there is a reserve account in the fund.

You will not need to obtain an actuarial certificate to claim ECPI if you want to claim the tax exemption using the segregated assets method.

Annual Audit report

An auditor needs to provide details if in his opinion:

- the financial report is not a true and fair presentation of the financial position of the fund

- the financial position of the fund may be, or may be about to become, unsatisfactory, or

- not satisfied the financial report has been presented fairly and in accordance with

· Australian accounting standards

· relevant statutory requirements

· other requirements.

If the auditor is not satisfied the fund has met these requirements, the auditor must clearly indicate in the audit opinion to the trustees and lodge a contravention report with the regulator.

The following statements are signed off by the auditor in his annual audit report;

.....perform the audit to obtain reasonable assurance as to whether the financial report is free from material misstatement

.... assurance that the trustee of the fund has complied, in all material respects, with the relevant requirements of the following provisions (to the extent applicable) of the SISA and the SISR including SISR 6.17

Note that SISR 6.17 guides us on Restrictions to pay benefits and talks about payments should be paid as per SISR division 6.3, where a member's preserved benefits in a regulated superannuation fund may be cashed on or after the satisfaction by the member of a condition of release.

SISR 6.17 which also refers to 6.17A which guides on payment of benefit on or after death of member.