If you think that underpaying your account-based pension or any other type of pension from your SMSF is not a problem, then you need to think again. A recent case in the Appeals Tribunal has severely punished someone for breaching the pension rules. The amount received in the breach was taxed at personal income tax rates just like salary and wages, without any exemptions or tax offsets.
The ATO has put its position clearly where an SMSF fails to comply with any of the pension rules in the Superannuation Industry (Supervision) Act (SIS Act) and Regulations. The consequences of correcting any underpayment of the pension go much further than just topping up the pension payment to the required minimum. Any breach also impacts the amount of tax payable by the fund and the treatment of each payment in the year of the breach.
Where a pension is found to be in breach of the rules, it is treated as ceasing from the commencement of the financial year in which the breach occurred. All payments made from the pension during the year are treated as a series of lump sums rather than the payment of an income stream. Also, any income earned on investments used to support the pension is taxed in the fund at 15% rather than being treated as tax-exempt.
In the financial year after the breach has occurred, because the pension is treated as having ceased, the ATO requires that if the pension is re-activated, it will be treated as an entirely new pension. This may have tax implications for estate planning purposes if adult children receive lump sum death benefits because the underlying taxable and tax-free components of the benefit may change.
Christine, who is 65 and retired, is the only member of her SMSF. She commenced her first account-based pension on 1 July 2021 with a total fund balance of $1.7 million. The minimum pension required to be paid during the 2021/22 financial year was 2.5% of the opening balance of $1.7 million on 1 July 2021, and the required minimum pension amount was $42,500. However, the SMSF made pension payments to Christine of $26,000.
When the fund accounts were being prepared in May 2023, Christine’s accountant and tax agent notified her that the amount of the pension paid to her for the 2021/22 financial year was less than the required minimum. This meant that the fund was in breach of the pension rules from 1 July 2021 and that the pension was treated as ceasing from the date it commenced on 1 July 2021. Any amounts received by Christine will be treated as a series of lump sums rather than income stream payments. This will have an impact on the amounts reported for purposes of Christine’s Transfer Balance Cap; however, the amounts she received will continue to be tax-free in her hands.
The income and taxable capital gains earned on the investments in Christine’s SMSF will now be fully taxed at 15% rather than tax-exempt. The reason is that where an SMSF has all its investments supporting pensions in the retirement phase, any income will be totally tax-exempt. However, where the pension breaches the rules, any income on investments is treated as if Christine’s SMSF is in the accumulation phase for the whole year.
In some situations, if the underpayment of the pension is minor, the Tax Commissioner is prepared to overlook the breach on a once and for all basis by exercising discretion under his General Powers of Administration. Discretion will be exercised, and the Commissioner will accept the pension as complying with the legislation where the underpayment is no more than 1/12th of the minimum amount required to be paid for the financial year For example, suppose Christine’s pension had been underpaid by no more than $3,542, which is 1/12th of her minimum pension for the 2021/22 financial year. In that case, the SMSF may have been able to rely on the Commissioner’s General Powers of Administration.
For anyone in receipt of a transition to retirement income stream (TRIS) not in the retirement phase that is in breach of the legislation, the consequences differ slightly from a pension that is in the retirement phase. A TRIS has a minimum pension percentage that is required to be met and a maximum pension percentage equal to 10% of the balance at the beginning of the year. A TRIS not in the retirement phase used to commence the TRIS is not counted against the person’s Transfer Balance Cap. Also, any income earned on the fund’s investments used to support a TRIS not in the retirement phase is taxed at 15% in all cases.
However, the main issue with breaching the pension rules for a TRIS not in retirement phase is that it will not be considered a pension for the whole year in which the breach occurred. It means that any payments received by the member in breach of the preservation standards will be taxed at full personal tax rates without any tax offsets applying. The recent decision in the Appeals Tribunal taxed a member of an SMSF who received amounts from a pension in breach of the rules at full personal tax rates – something that should be avoided at all costs.
Over the next few weeks to the end of June, anyone in receipt of a pension from their SMSF and their advisers should be checking to see that at least the reduced minimum has been paid to them for this financial year.
Anyone in receipt of a TRIS that is not in the retirement phase should check to ensure they have met the minimum payment requirement. Also, they need to check they have not exceeded the maximum TRIS payment equal to 10% of the account balance at the commencement of the financial year. Failing to meet any of these requirements may mean a lot more work when the accounts for the SMSF are prepared and explaining things to the fund’s auditor.
Don’t forget that the 2022/23 financial year is the last year in which the 50% reduction of the standard pension percentages applies. For example, the reduced minimum percentage of 2.5%, which applied to Christine in our case study, will increase to 5% which applies to anyone receiving a pension from their SMSF between ages 65 and 74.
Not meeting the pension rules for your SMSF can mean extra tax and costs – something you should avoid.