Basic Considerations for a Member Voluntarily Commuting an Income Stream
Income stream commutation rules are outlined in the SIS Regulations. A member of a superannuation fund may elect to commence an income stream (most commonly, an account based pension) once a condition of release has been satisfied. A condition of release could be met where, for example, the member retires or reaches the age of 65. The member must generally be over the age of 60 for the income stream to be tax free when received. Alternatively, the member of the superannuation fund may prefer to partially of fully cash out their superannuation by taking a lump sum payment. A mixture of an income stream and lump sum withdrawal is also a possibility.
If the member has elected to commence an income stream, the member is not (usually) permanently locked in to that income stream. The member may subsequently commute part or all of the income stream to a lump sum which can be cashed out of the superannuation environment. The member may also commute the income stream to a lump sum which is rolled back from pension phase to accumulation phase. This enables the commuted amount to remain within the tax concessional superannuation environment.
Put another way, the member may convert the form in which they draw out superannuation from a pension style withdrawal to a lump sum payment. The lump sum amount does not need to be cashed out of superannuation and can instead be held in the superannuation fund in accumulation phase.
There are many potential reasons why a fund member may seek to commute an income stream.
For example:
- the fund member may prefer not to be bound by the requirement to draw out the minimum annual pension amount. The superannuation interests commuted and rolled back to accumulation phase can continue to remain in the superannuation environment without a requirement to draw out a minimum amount. However, the catch is that earnings on capital held in accumulation phase are taxed at 15% and the realisation of CGT assets held in accumulation phase are taxed at 10% if held for at least 12 months.
- the value of capital supporting the pension may be at risk of decreasing due to market volatility and economic downturn.
- the member may simply prefer the cash immediately or prefer to manage capital personally outside of the superannuation environment.
- The commutation of pension phase capital supporting a retirement phase income stream results in a debit to the transfer balance account. This frees up space under the member’s personal transfer balance cap. This may enable the member to, for example, re contribute non concessional amounts into superannuation in order to increase the tax free component. This may improve tax outcomes where, upon death of the member, the superannuation balance is intended to be distributed to non dependants (as defined under the SIS Act) of the deceased. The payment of the income stream to the fund member does not free up transfer balance cap space as commutation does.
- Commutation also enables the taxpayer to receive payment by via the in specie transfer of assets (other than cash). Cash is generally the only form of payment possible under an income stream. Therefore, commutation may be sought by a member that wants to retain assets held by the fund.
It is worth noting that, except in respect of a transition to retirement income stream, there is no maximum annual income stream amount that may be drawn out by the member. Therefore, it will often be easier for a member to simply request the withdrawal a larger income stream amount instead of commuting part of their income stream to a lump sum cash withdrawal.
The Requirements to Voluntarily Commute an Income Stream
For a voluntary commutation, the fund member must first request the commutation with the superannuation fund. This request must be made before the commutation is initiated. The superannuation fund will also need to follow certain processes to complete the commutation process. This includes keeping records of the commutation decisions made, disclosing the commutation to the ATO on the transfer balance account report and making the minimum annual pension payment to ensure the income stream remains compliant.
With regards to the minimum annual pension payment:
- In respect of a full commutation only, the minimum annual amount can be decreased to reflect the numbers days as a portion of the entire year income that the pension is no longer payable. This amount payable is calculated based on the number of days between the start of the income year and the date of commutation (including the date of commutation).Where there is full commutation, the minimum (reduced) pension payment will need to be made before the commutation occurs.
- In respect of a partial commutation, the minimum annual pension payment must be made in full for the entire income year. That is, there is no pro rating opportunity. This is because the minimum annual payment will continue (as there is a left over balance to support the pension) and the annual minimum pension payment is based on the balance of the pension account as at 1 July (not the reduced balance following commutation). Where there is partial commutation, the minimum pension payment is not required to be made before the commutation occurs. However, there must be sufficient assets remaining in the pension account to meet the minimum pension payment standards for that income year which is based on the balance of the account at the most recent 1 July.
- Note that any pension payment made within the income year but prior to a partial or full commutation will effectively count towards the discharge of the minimum annual payment.
- Also note that amounts commutated do not count towards satisfying the minimum annual pension payment requirements.
As an example, of the interaction between commutation and the minimum annual pension standards, take Stephen who commences an income stream (account based pension) on 1 July.
The minimum annual payment determined by reference to his age is 8%. The balance of the account supporting his income stream is $1,000,000. Therefore, at a minimum, he must be paid at least $80,000 for the income year.
If he requests (voluntarily) or the fund is required (mandatorily) to commute his income stream, the maximum he can commute under partial commutation is $920,000 ($1,000,000 account balance – $80,000 minimum annual payment).
If respect of a full commutation, the minimum annual payment will continue to apply but on a reduced / pro rata basis to reflect the part of the income year that the income stream remained in effect i.e. the period between 1 July and the date of commutation (as this is the period when the income stream was payable).
For example, if the minimum annual payment is 8% of the account balance and the commutation occurs on 31 July, the minimum annual payment is effectively:
The account balance at 1 July x 8% x (31 days / 365 days).
Remember that the relevant period that the annual payment is payable includes the date of commutation.
Note that any amount commuted but which remain in superannuation (e.g. superannuation interests rolled back into accumulation phase) will have earnings subject to a rate of tax of 15%. The rate of tax applied to capital gains is 10% if the relevant CGT asset has been held for at least 12 months.
Care should be taken to ensure that the partial commutation of an income stream does not unnecessarily occur before pension phase assets are realised. This is may inadvertently cause CGT to apply on the realisation of the assets necessary to facilitate the commutation. In this way, the exiting capital which supported the income stream may be needlessly taxed at 10% or 15%, instead of 0%.
Mandatory Commutation Imposed on the Superannuation Fund
Although commutation is most commonly a voluntary action, there are certain instances where it the trustee of the superannuation fund will be required to make a commutation. Such an instance includes where a fund member has exceeded their personal transfer balance cap and the ATO has issued an excess transfer balance determination.
Remember that the personal transfer balance cap is the maximum superannuation interests that can be transferred into pension phase to support a retirement phase superannuation income stream. The transfer balance is tracked through the transfer balance account which involves a system of debits and credits.
If the ATO determines that a member has exceeded their personal balance cap and issues the relevant determination, the ATO will provide the fund with a commutation authority notice. This provides the fund with authority to either commute the transfer balance cap excess into an accumulation phase account (unless the income stream is supporting a death benefit payment) or to commute the excess to a lump sum which is cashed out of the superannuation system.
The fund must then provide the ATO with a transfer balance account report which contains details of the commutation. This includes advice on whether the SMSF has:
- complied in full with the commutation authority, or
- complied in part with the commutation authority, or
- has not complied with the commutation authority for example, if the member is deceased of if the commutation authority relates to a capped defined benefit income stream.
There may be instances where the available superannuation interests supporting the income stream are not sufficient to cover the transfer balance cap excess. If that is the case, such detail will need to be reported on the transfer balance account report. The fund will generally need to commute the maximum amount possible (determined after the minimum annual payment has been taken into account).
Note that there is generally no need to comply with a commutation authority where a member has become deceased. However, the transfer balance account report will still need to be lodged by the due date to advise the ATO that the member is deceased and that that is the reason the fund is not required to comply with the authority.
As suggested above, despite the commutation authority, the minimum annual pension payment remains applicable in order for the income stream to continue to be recognised as compliant with the minimum pension standards. This may mean that the amount commuted is less than the amount set out on the commutation authority notice. If so, the reason for the partial compliance with the commutation authority should be disclosed on the transfer balance account report.
The commutation must generally be made within 60 days of the date of the commutation authority notice. This due date will be shown on the notice.
The fund member must be notified in writing within 60 days of the date of the commutation notice. The fund must provide details of the actions taken in response to the commutation authority.
The failure to comply with the commutation authority by the required date will cause the income stream to stop being treated as a retirement phase income stream. This will upset some of the tax concessions available to the member. For example, any income derived from capital supporting retirement phase income stream will no longer be tax free. Further penalties may also apply.
Remember that usually the fund has a choice between commuting an amount into a lump sum rolled back into accumulation phase or simply cashing out the lump sum. The fund will generally consult the member to determine if the member has a preferred approach in mind. Note that if the commutation authority is in respect of a death benefit income stream, the only option is to cash out by lump sum.
The fund can lodge an objection to a commutation authority if the view is held that it contains errors. The ATO may then revoke or amend the authority. If the revocation or amendment is received before the due date to comply with the authority, then the terms of the revocation or amendment will be effective. An amended authority will contain instructions on revised actions necessary to ensure compliance (if any). If no revocation or amendment is received by the due date to comply with the authority, the authority should be complied with by the due date.
Any excess over the member’s transfer balance cap will attract excess transfer balance tax. The fund member will usually be provided with a notice of assessment setting out the tax liability. This must generally be paid within 21 days of the date of notice. The operation of the excess transfer balance tax is addressed in other BrisTax articles. Remember that the burden of the tax falls on the member of the fund, not the trustee of the superannuation fund.
The above described rules and processes may be modified (or not applicable at all) if an income stream is a market linked pension or a capped defined benefit income stream. The relevant rules in respect of these forms of income streams are not addressed in this article.
Please also note this article does not address the impact of commutation on entitlements to Centrelink and other government benefits.
This article is general information only and does not provide advice to address your personal circumstances. To make an informed decision you should contact an appropriately qualified professional.