The proportioning rule is used to calculate the tax free and taxable components of a superannuation benefit. Having a sound understanding of this rule is key to many super strategies.
Overview –– proportioning rule
The proportioning rule provides that the tax free and taxable components of a superannuation benefit are taken to be paid in the same proportion as the tax free and taxable components of the member’s superannuation interest from which the benefit came. This means that when paying a superannuation benefit, a member cannot decide whether that benefit is paid from the tax free or taxable component. Instead, the tax free and taxable components of the superannuation benefit will be reflective of the tax free and taxable components of the member’s particular superannuation interest. Thus, a member cannot simply select or ‘cherry pick’ just the tax free component to pay less tax.
In this article, we refer to the following terms as they are used in s 307-125 of the Income Tax Assessment Act 1997 (Cth) (ITAA):
- Superannuation interest — refers to a member’s accumulation or pension interest as appropriate.
- Superannuation benefit — a payment from a superannuation fund to a member either as a lump sum or pension payment.
- Tax free component — this generally includes all non-concessional contributions made after 30 June 2007 that are not included in the fund’s assessable income and the ‘crystallised segment’ that broadly includes numerous tax free components that existed prior to 30 June 2007.
- Taxable component — this generally includes concessional contributions and earnings and any capital appreciation from investments in the fund. Broadly, the total value of a member’s superannuation interest less the value of the tax free component.
Please note that these terms may have other meanings in other legislation. However, this article is primarily focused on the meaning of the terms from a taxation and superannuation law perspective.
In an SMSF context a member can only have one accumulation interest, however, each pension that is commenced will form its own superannuation interest. When a member decides to commence a pension, the tax free and taxable components will be locked at that time.
The time to determine the tax free and taxable components of a superannuation benefit differ depending on whether a lump sum or pension is provided. In summary, these proportions are determined at the following times:
- Lump sum payment — just before the benefit is paid.
- Pension payment — on the date the pension commences.
To illustrate how this works in respect of pensions, consider the following example.
For an accumulation interest, the tax free component is likely to remain static while the taxable component can fluctuate with investment markets and earnings (or losses) accrue and in some cases on a daily basis.
Let’s assume that Ben has an accumulation interest valued at $200,000 with a $100,000 tax free component (ie, 50% tax free). If Ben’s accumulation account increases in value to $400,000, the tax free component remains $100,000 (therefore the account is now 25% tax free). On the other hand, if Ben’s accumulation interest decreases to $80,000, his tax free component is now $80,000 (ie, 100% tax free).
When a pension is commenced, the tax free and taxable components are locked in at that time. Thus, each payment will reflect the tax free and taxable components of the accumulation interest when.
Referring to Ben’s example above, if Ben commences a pension when it is valued at $200,000 with a $100,000 tax free component each pension payment will be 50% tax free. Note that this proportion does not subsequently change despite increases or decreases in the value of the assets supporting that pension.
However, it is worthwhile noting that if the pension assets increase over time, the tax free component effectively grows in amount (but not in proportion). Conversely, if the pension assets decrease over time, the tax free amount can decrease in amount (note, for example, that the tax free amount in Ben’s accumulation account decreased from $100,000 to $80,000).
Timing and value
Accordingly, the following general rules should be noted:
- Where assets are going to increase in value, the tax free component is maximised by commencing a pension sooner rather than later (locking in the tax free component to grow proportionately).
- Where assets are going to decrease in value, the tax free component is maximised by commencing a pension later rather than sooner (allowing the decrease in assets to erode the taxable component).
Making sure you get the timing right and monitoring the value of your accumulation and pension interests can make a significant difference. In a nutshell, understanding the proportioning rule is key to maximising your super strategies.
- Calculating components of a super benefit (ATO resource)
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This article was prepared on 27 November 2020 and is for general information only and should not be relied upon without first seeking advice from an appropriately qualified professional.