In this guide
Commuting a pension simply refers to the process where a super fund member converts all, or part, of their existing pension benefit into a lump sum payment.
There are a number of circumstances where an SMSF member might consider commuting all or part of their existing pension, including:
- An unexpected need for cash for a large purchase or to help a family member
- A desire to combine multiple pension accounts
- The transfer of additional funds from an accumulation account into a single pension account
- The receipt of a reversionary pension from their deceased partner, which would result in the member exceeding their transfer balance cap.
If this is something you are considering, then you need to be aware of the specific process that SMSF trustees follow.
How does it work?
This strategy involves shifting all, or part, of an existing pension balance back into the member’s accumulation account within the SMSF.
Once this has been carried out, the member can then access a lump sum from their accumulation account or simply leave the amount in the accumulation phase.
To do this, a member needs to make a request in writing to the fund trustees for their existing entitlements to future pension payments to be commuted. Essentially ‘rolling’ back part or all of the pension balance to the accumulation account. The member would then, where relevant, request in writing for a lump sum to be paid out from the fund.
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 all or part of a member’s pension balance is transferred to their accumulation account, there is no capital gains event unless the fund sells or disposes of an existing fund asset.
What do you need to know?
When a member requests a commutation from their pension, it is important to remember that the trustees are still required to pay the pro-rated minimum annual pension for the year. This is to make sure that the fund earnings on the assets supporting the pension prior to commutation are considered to be exempt current pension income (ECPI) for tax purposes.
For example, if an SMSF member fully commutes their pension on 1 March, before doing so, the SMSF trustees would be required to pay at least the pro-rata amount for that pension for the number of days in the financial year that the pension was in place.
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.
| Age of beneficiary | Percentage factor |
|---|---|
| Under 65 | 4% |
| 65 to 74 | 5% |
| 75 to 79 | 6% |
| 80 to 84 | 7% |
| 85 to 89 | 9% |
| 90 to 94 | 11% |
| 95 or more | 14% |
Source: SIS Act
It is also important to note that where a full commutation of a pension occurs, the fund trustee will need to complete a transfer balance account report and lodge it with the ATO, noting the cessation of the member’s pension.
What are the pitfalls?
One of the biggest pitfalls of commuting a pension to a lump sum would be the different tax treatment of the income earned on the assets.
The earnings on super balances supporting pensions are tax free, whereas any income earned on accumulation balances is taxed at 15%, although that is still lower than most individuals’ income tax rates. This is an issue that needs to be considered where the amount commuted from a pension remains within the member’s accumulation account.
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There are also issues around capital gains tax on assets that are transferred from the SMSF to the member as an in-specie payment, as mentioned earlier.
Also, keep in mind that the timing of a full commutation is important. It needs to be made after the pro-rated minimum drawdown for the year has been met in order for the income earned on the pension prior to commutation to be considered ECPI.
Starting a pension again
Where an SMSF member commutes all or part of their pension and retains those amounts within their accumulation account, they can, at a later date, choose to restart a pension.
If they do, they will need to go through many of the same processes they did when they started their original pension, such as calculating the taxable and tax-free portions of the funds supporting the pension.
A fairly common example of when an SMSF member may wish to fully commute their pension occurs when the member makes additional super contributions after the commencement of their pension. These contributions need to be allocated to the member’s accumulation account in their SMSF, they can’t be added to the existing pension.
For ease of administration, the SMSF member may then request to fully commute their existing pension and roll the pension balance back to the accumulation phase, then combine these balances. Once this has been carried out, the member can then request to commence a new, larger pension from their accumulation account using some or all of their member balance.
A partial commutation
Most of what has been mentioned above relates to the full commutation of a member’s pension, where a member stops their entire pension and ‘rolls’ or transfers the balance back to the accumulation phase.
Another option is to partially commute a pension, by moving some of the existing pension balance back into accumulation phase, leaving some remaining in retirement phase.
If a pension is partially commuted, the minimum is still required to be paid for the year, so SMSF trustees need to make sure that:
- The minimum amount is paid before commutation
- Sufficient assets remain to meet the minimum pension payment standards for that year, based on the original value of the income stream at the start of the year.
The bottom line
SMSF pensions can be very flexible and can provide great retirement income outcomes for fund members when they are used appropriately. But keep in mind that there are also compliance and reporting obligations that need to be addressed when commuting an existing pension.
If you are considering a commutation from an existing pension, make sure you have in place the written documentation that sets out what you are doing. Also, consider discussing this with your fund administrator, as they may have standard documentation or processes you can adopt.
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