Superannuation law is currently undergoing one of the most significant periods of change in almost a decade. This has led to practitioners having to reconsider the conventional wisdom on various issues relating to superannuation.
One such area where previous standard practice needs to be revisited is succession planning.
In this article I want to focus on one aspect in particular: should a pension from a self managed superannuation fund (‘SMSF’) be commenced as an automatically reversionary pension or not?
What do I mean by an ‘automatically reversionary’ pension?
I use the term ‘automatically reversionary’, which has a very specific meaning. Namely, I use it to refer to a pension that, upon the death of the initial recipient of the pension, continues to be paid to someone else (typically a spouse, who I will refer to as the ‘reversionary beneficiary’) instantly upon the death of the initial recipient. In other words, upon the death of the initial recipient, the pension continues to be paid to the reversionary beneficiary without anything further required to be done or determined.
For example, upon the death of the initial recipient of an automatically reversionary pension, neither the trustee of the fund nor the reversionary beneficiary needs to do anything before the reversionary beneficiary becomes entitled to receive the pension. If the trustee of the fund and/or the reversionary beneficiary needed to do something, then the pension would not be an automatically reversionary pension: if the trustee of the fund and/or the reversionary beneficiary did have to do something and then did that thing in order to ensure that the pension continued to be paid, although the pension might have reverted and thus could be said to be a reversionary pension, it is not an automatically reversionary pension.
What has been the ‘wisdom’ in the past?
When the Income Tax Assessment Amendment (Superannuation Measures No. 1) Regulation 2013 (Cth) was enacted (to amend the Income Tax Assessment Regulations 1997 (Cth)), it meant that if a pensioner died without an automatically reversionary pension, the pension exemption would still continue.
The draft of the legislation suggested that it was important to still make pensions automatically reversionary because otherwise, upon death the interest supporting the pension would mix with any other interests in the fund. However, the finalised version of the legislation addressed and clarified that even if a pension is not automatically reversionary, broadly, the deceased’s pension interest would not mix with any other interests in the fund.
Accordingly, on its face, there was no longer any advantage in having an automatically reversionary pension.
However, there was a ‘hidden’ reason for when an automatically reversionary pension was still important. Namely, if the fund had a life insurance policy, any pay out upon death would generally form part of the taxable component unless there was an an automatically reversionary pension.
If there was an automatically reversionary pension, the insurance proceeds should take on the tax free and taxable component proportions of the pension. On the flip side, if the pension was not automatically reversionary, the insurance proceeds would generally form part of the taxable component.
For example, consider Preston. He was receiving a $200,000 pension from his SMSF, funded entirely of the tax free component. The pension was not automatically reversionary. The fund also maintained a life insurance policy in respect of Preston, the premiums were charged against Preston’s pension account. Preston died. The policy paid out $200,000. The interest was now $400,000 but would generally have been comprised of a taxable component of 50% and a tax free component of 50%.
As a counter example, consider Jennifer. Jennifer’s situation was the exact same as Preston’s, except Jennifer’s pension was automatically reversionary. When the insurance proceeds were received, they took on the proportions of the pension (ie, in this instance, 100% tax free component). Accordingly, the person who ‘inherited’ Jennifer’s automatically reversionary pension would have received $400,000 of entirely tax free component.
Further, certain changes to social security law that took effect from 1 January 2015 meant that an automatically reversionary pension could also have been important in the following circumstances:
- a person was in receipt of an account-based pension that commenced before 1 January 2015
- that person was in receipt of social security benefits (eg, Commonwealth seniors health card) and
- that person had a spouse and upon that person’s death, if the spouse was still alive, the deceased would have wanted their spouse to receive their superannuation death benefits in the most tax efficient way (typically as a pension) and — to the greatest extent possible — without jeopardising their spouse’s entitlements to social security benefits.
In such circumstances, it could also have been worthwhile to ensure that a pension is automatically reversionary.
However, the above two circumstances were somewhat rare. That being said, the potential downside to nevertheless making a pension automatically reversionary was relatively small. Accordingly, I suspect many practitioners had a default tendency to making pensions automatically reversionary.
What has changed?
Treasury has released certain draft legislation. I emphasise that this is just draft legislation. However, if it becomes law without any changes, it will mean that from 1 July 2017, if a person dies with an automatically reversionary pension, a credit will arise in the transfer balance account of the reversionary beneficiary exactly six months from death. If the credit results in the transfer balance account exceeding the personal transfer balance cap of the reversionary beneficiary, this can cause all sorts of issues for the reversionary beneficiary, including in the most extreme manifestation, a tax liability.
I do stress though that the reversionary beneficiary has six months to determine what do to before any real issues could arise.
However, importantly, that six-month period starts counting from the moment of the initial pensioner’s death and the initial pensioner is almost always the reversionary beneficiary’s husband or wife. Upon the death of a husband or wife, many people are grief-stricken and will not be in a position to seek advice and make an appropriate decision (eg, commute an excess) within six months of their loved one’s death.
However, if the pension is not automatically reversionary, the six-month period will not start instantly upon death. Rather, it will starts when the reversionary beneficiary becomes the recipient. In essence this might result in a few months of ‘breathing space’ for the grieving widows and widowers.
Bear in mind that this six-month period is only contained in draft legislation. However, if that draft legislation is ultimately made without any significant changes, then practitioners should be aware that non-automatically reversionary pensions might become a more attractive ‘default’ tendency as they may allow an SMSF member to have slightly more time to seek advice and make decisions after the death of a loved one.
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This article is for general information only and should not be relied upon without first seeking advice from an appropriately qualified professional.