What to do when paying a pension for the first time.
Early in a new financial year, many self-managed superfund (SMSF) investors will think about using their fund to pay a pension for the first time.
Many mistakes are made with pensions, often through ignorance of some basic rules. Usually it’s the old “not planning to fail but failing to plan” problem.
Many of these mistakes can be avoided if you follow the nine steps outlined below.
1. Check your fund’s trust deed
What pensions, if any, are permitted? What rules does it demand? Does it permit asset segregation? Does your trust deed permit some or all of the pension’s account balance to be taken as a lump sum? Does your trust deed need to be updated before your pension commences? Make sure you understand what is and isn’t permitted by the terms of your fund’s trust deed.
2. Detail why the pension is being paid
There are three typical reasons:
• You’ve requested a pension be paid
• You’ve reached an age (for example 65) at which your fund’s trust deed says you have to take your money out as a lump sum or pension
• You’ve requested a Transition to Retirement pension
You’ll need suitable documentation to capture whichever option is relevant. For example, under the first reason you’ll need paperwork showing that you’ve retired.
Under all options, your SMSF administrator will want to verify your date of birth.
3. Consider a Product Disclosure Statement (PDS)
When a super fund pays a pension, the trustees should consider issuing a PDS to the pensioner.
There are formal detailed rules that specify what should be in a PDS. ASIC has also issued guidelines, which assist financial product issuers to decide what should and shouldn’t be in these documents.
Most of you won’t have time to go through the legislation and other documentation. Fortunately, your fund administrator’s trust deed supplier has probably created a generic PDS, which you can amend for your specific circumstances.
4. Formally accept the offer
As a member, you formally accept your SMSF trustee’s offer, including the initial dollar value for the pension.
If this purchase price is coming from money that’s not already in the fund, then what is its source? Are the proceeds coming from new contributions? Will these contributions be subject to tax when received by the trustee?
Or will some or all of these proceeds be coming from super benefits rolled over or transferred from another super fund, an employment termination payment, or other similar type of benefit?
With taxation and rollovers involved, it might be some time before the exact purchase price of the pension is known.
5. Clarify all the pension’s details
There are two important parts here: First, the value of the assets backing the pension. These must be based on prevailing market value and from here the minimum income payment can be determined.
If you’ve requested an income payment less than the minimum allowed by the super regulations, then at this point the trustee will need to formally communicate this to you.
Once the value of the pension has been set, no new amounts can be added to it via contributions or rollovers.
Secondly, the taxable and tax-free components of the pension – this mightn’t seem a big deal because once you hit 60 years of age your pension payments will be tax-free. However, the tax laws demand you keep accurate records here.
This can be an important issue for estate planning purposes if your pension assets will be paid to any non-dependent adult children on your death.
6. Document the pension
The SMSF trustee must fully document the pension for its own records – for example, the commencement date, date of first pension payment, how often pension payments will be paid and how.
7. Make pension payments on time
You need to pay the minimum required by the super laws each financial year – a good way to do this is to set up a direct debit facility and make sure your super fund always has sufficient money in the bank to make these payments.
All pension payments must be made with cash or cash equivalent, such as cheque or direct debit. Post-dated cheques are best avoided.
8. Clarify financial accounts
When the pension commences, the SMSF trustee also needs to change their financial accounts – from this specific date, all earnings on the assets backing the pension are tax-free.
It’s important you can clearly identify income or capital gains received by the fund from this commencement date onwards.
Don’t forget that in most cases you’ll only get this tax exemption if you get an actuarial certificate each year.
9. And finally – understand that you wear two hats
You wear one hat as a member and the other as trustee. As trustee, you must deal with yourself as a member impartially.
As difficult and as silly as this might sound, this is an important aspect of trusts and super funds laws in particular. This is sometimes referred to as the arm’s-length rule.
Tony Negline has worked in financial services for more than 25 years and has been heavily involved in self-managed super funds since mid-1994. He writes about SMSF matters for a wide range of audiences including accountants, auditors, financial advisers and SMSF trustees.