Once a pension starts in an SMSF, the trustee has a legal obligation to make sure it meets minimum payment obligations each year. Unfortunately, it’s an easy thing to get wrong so it pays to understand what to do if it happens.
First, make sure you find out quickly because there is something you will need to do to fix it. So even if you don’t read all of this article, at least double-check the amount taken from your pension in 2024/25. You don’t need your audit and financial statements for that income year to be finished to check this.
Why is it so important?
Underpaid pensions are considered to have ‘failed’. That means they don’t get the same tax breaks as compliant pensions.
In particular, most pensions are what’s known as retirement-phase pensions – income streams in place for people who are over 65 or between 60 and 65 and retired. These pensions entitle the fund to a special tax exemption allowing some or all of their fund’s investment income, interest, dividends, trust distributions, rent and the like, to be exempt from tax. Unfortunately that treatment is only available to pensions that meet all the rules, one of which is paying the stipulated minimum drawdown amount each year.
In the past, failing to pay the right amount during the year was a problem, but only for one year, after which it tended to fix itself. For 2023/24 and earlier financial years, failed pensions lost the tax break for the year of failure, but automatically got it back the following year, as long as the right amount was paid in the subsequent year. There were also other consequences for the members involved that meant:
- any payments they took during the year were treated as lump sums rather than pension payments. For people who had retired and were over 60, this didn’t really matter much as the payment was tax-free to the member anyway, but also
- the percentage of the pension account that was considered a tax-free component had to be recalculated and usually it reduced. This was slightly problematic for people hoping to minimise taxes for their adult financially independent children if they, the pensioner, died with a large super balance. The tax-free component of any death benefit paid from a pension account is tax-free to the child, but the rest is not. Obviously it’s nice to have the highest possible tax-free component.
Importantly, funds that didn’t make enough pension payments didn’t have to take any action to get things back on track the following year.
For 2024/25 and beyond, however, things are different.
Now, funds that underpay pensions see much more drastic consequences for both the fund and the members concerned whereby:
- the rescinded tax break on the fund’s investment income lasts forever, not just for the year of failure. The only way to get it back is to stop the failed pension and start a new one in its place. The trouble is most people don’t work out their pension has failed until well after the end of the financial year. That’s why checking now is important. Trustees must determine if their SMSF made sufficient pension payments for 2024/25. If not, quick action must be taken immediately to ensure the income stream tax exemption is restored as soon as possible, and
- if the member had an accumulation account, that is monies in the same fund not part of a pension, the two accounts are now considered mixed rather than staying separate. This is important too. Some people carefully orchestrate when they start income streams to make sure they maximise the tax-free percentage in their pension account. All that will be undone if their SMSF trustee accidentally underpays their pension.
And there are others.
Why the change?
The ATO issued an update to an old taxation ruling, first issued back in 2013, and set out its view on how these things work. Its view was quite different to pretty much everyone else’s. Fortunately, it stopped short of requiring funds to go back and amend many years’ tax returns and essentially drew a line in the sand at 1 July 2024. The ATO won’t take compliance action on failures in 2023/24 and earlier, meaning it won’t ignore an issue if detected, but it won’t go looking for these breaches.
Is there anything you can do?
First, be vigilant about how much you need to withdraw from your SMSF income stream. Have you started a new pension during the year? Make sure that was taken into account. Had your financial statements adjusted? Make sure the pension payments for the coming year were also updated. Skating close to 30 June? Make sure you get those pension payments actually into your personal bank account comfortably before the end of the year.
If it’s too late, that is, you’re facing a failure in 2024/25, often the best thing to do is act promptly. You might want to stop the old pension as soon as possible and start a new one in its place. Make sure you ask your accountant how much can be put into the new one as some calculation quirks mean it may not necessarily be as much as you had in the old one.
There are some circumstances where the ATO can ‘forgive’ a failure and let you ignore it entirely. This is automatic if the error meets a number of conditions, one of which is that the pension was underpaid by less than one-twelfth of the proper amount. But this remedy is something that can only ever be used by each fund once, that is, not once per member or once per pension, but just once per fund forever. However, you should not assume this will apply to you and you should talk to your accountant about it.
There are also other consequences to stopping and restarting pensions. For example, if you’ve had your pension for a long time, and it’s entitled to some special grandfathering conditions, stopping it will mean you lose this. Make sure you understand exactly what will happen before taking action.
Pensions are extremely valuable structures if they are well managed. But it’s worth making sure you stay informed about your obligations as a trustee so you can avoid the simple mistake of taking too little or too much from one.
This article first appeared on www.heffron.com.au.
Meg Heffron is managing director of Heffron.
