Should you set your SMSF client with an account-based reversionary pension? In my article ‘Don’t die in transition without a backup plan‘ I highlighted the issues with establishing a reversionary Transition to Retirement Income Stream (TRIS), but what about your regular run of the mill Account-based Pensions?
Account-based reversionary pension – the FOR case for account-based
The introduction of the Transfer Balance Cap makes a compelling case FOR account-based reversionary pensions. Firstly, the 12 months reporting delay gives a fund access to exempt pension income on the deceased’s pension balance. The reversions own pension continues to gets the exemption even though the combined value may be higher than $1.6m. This provides the fund with a great tax outcome for 12 months following the death of a member. Where both spouses have in excess of the $1.6m, reversionary pensions appear to make sense. The 12 months gives ample time to make necessary commutation arrangements for the surviving spouse’s benefit. Just because it makes sense doesn’t mean it is always the right decision.
Account-based reversionary pension – the AGAINST case
One change, recently introduced, makes arguing AGAINST account-based reversionary pensions a worthwhile exercise. It’s also relevant to death benefit income streams in general. Is it in the best interest of all parties for a pension to revert? By disallowing non-concessional contributions for individuals with more than $1.6m in super, re-contribution strategy are affected. This can result in an increased tax liability to non tax dependants on the payment of a death benefit. A reversionary pension to a spouse may result in a larger final death benefit resulting in a higher tax liability.
The Estate Planning Consideration
Let’s consider a couple each with a pension worth $1.6m and both comprising 100% taxable component. They have two adult children. First instinct is to revert pensions and pay remaining benefits to adult children on the death of the second spouse. After the first spouse dies all earnings in the fund are exempt for 12 months. In subsequent years let’s assume that 50% of all income is exempt from tax. On the assumption that the fund returns 5% on an annual basis, the saving in year one is $12,000. Then the second spouse dies and we have to pay $3.2m to the children. The best case scenario is a 15% tax rate resulting in a tax liability of $480,000.
If the pension is not reversionary, then we can pay $1.6m out tax free to the surviving spouse. Assuming the money is invested and generates the same 5% on the outside then based on current tax rates the spouse, rather than the fund, will pay tax in the first year of approximately $17,500. From year two this would mean the overall tax liability would be $5,500 higher. However, tax on the second spouses death benefit of $1.6m, payable to the children, is $240,000. From an overall benefit position the tax is going to be lower if a death benefit is paid out as a lump sum on the death of the first member, even if a number of years have passed by.
Same result achievable
Of course all this example points out is that it may not be in the best interest of the clients to retain amounts in superannuation when the first spouse dies. Retaining money in the super environment is one of the primary reasons behind paying pensions. There are also examples that will show an account-based reversionary pension is the ideal strategy. Take the approximate 85% of SMSF members who have less than $1m and the reasonable proportion of those who have already have a tax-free component. These members may have the ability to utilise re-contributions. They will also be able to highlight that there is little difference between having a reversion and having discretion, but there is a difference!
What the example doesn’t highlight are two factors that can play a big part in the decision making process, investment returns and complacency. A credit to a members transfer balance cap for a reversionary pension doesn’t factor in the investment movements in the 12 months that proceed the death of the member. In a growth market this is a great thing, in a downward market it might be the difference between having to commute an existing pension or not. Complacency may seem an odd suggestion but how many people have you heard say that one of the benefits of an account-based reversionary pension is that you don’t have to do anything for 12 months. If you have a second spouse with ailing health then not doing anything might not be a great move.
There is no doubt that reversionary pensions are worthwhile for a significant proportion of SMSF retirees but they may not be in the best interest of all SMSF beneficiaries. Setting up a pension to revert is not necessarily going to be problematic, inaction in the 12 months following the death of a member may be. Don’t forget, exempt pension income is also attributable to assets supporting a pension that is awaiting a trustee decision, again timing and market movement are important.