Superannuation law is currently undergoing one of the most significant periods of change in almost a decade. This is causing practitioners to have to rethink a lot of commonly accepted wisdom.
One such area where previous standard practice needs to be revisited is succession planning.
I want to focus on one aspect in particular: should the general rule of thumb be that a pension from an SMSF be commenced as an automatically reversionary pension or not?
I use the term “automatically reversionary” to have 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 having 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 need to do anything before the reversionary beneficiary becomes entitled to receive the pension. If the trustee of the fund and/or the reversionary beneficiary had 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 being paid, although the pension
might have reverted and thus could be said to be a reversionary pension, it is not an automatically reversionary pension.
When the Income Tax Assessment Amendment (Superannuation Measures No. 1) Regulation 2013 was made (which amended the Income Tax Assessment Regulations 1997), it meant that if a pensioner died without an automatically reversionary pension, the pension exemption would still continue.
‘Mixed up’ interests
The draft of the legislation had suggested that it was important to still make pensions automatically reversionary because if not, 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 will 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 when an automatically reversionary pension was still important. Namely, if the fund had a life insurance policy, any payout upon death will generally form part of the taxable component, unless there was an automatically reversionary pension.
If there is 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 is not automatically reversionary, the insurance proceeds will generally form part of the taxable component.
For example, consider Preston. He is receiving a $200,000 pension from his SMSF, funded entirely of the tax-free component. The pension is not automatically reversionary. The fund also maintains a life insurance policy in respect of Preston; the premiums are charged against Preston’s pension account. Preston dies. The policy pays out $200,000. The interest is now $400,000 but will generally be comprised 50 per cent of the taxable component
and 50 per cent of the tax-free component.
As a counter example, consider Jennifer. Jennifer’s situation is the exact same as Preston’s, except Jennifer’s pension is automatically reversionary. When the insurance proceeds are received, they take on the proportions of the pension (in this instance, 100 per cent tax-free component). Accordingly, the person who “inherits” Jennifer’s automatically reversionary pension receives $400,000 of entirely tax-free component.
Further, certain changes to social security law that took effect from January 1, 2015, mean that an automatically reversionary pension can also be important in the following circumstances:
• A person is in receipt of an account-based pension that commenced before January 1, 2015
• That person is in receipt of social security benefits (eg, Commonwealth seniors health card)
• That person has a spouse and upon that person’s death, if the spouse is still alive, they want the 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 the spouse’s entitlements to social security benefits.
In such circumstances, it could also be worthwhile to ensure that a pension is automatically reversionary.
Potential downside
However, the above two circumstances are somewhat rare.
That being said, the potential downside to nevertheless making a pension automatically reversionary was relatively small. Accordingly, I suspect many practitioners have a default tendency to making pensions automatically reversionary.
Treasury has released certain draft legislation. I stress that this is just draft. However, if it becomes law without any changes, it will mean that from July 1, 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 sort 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 to do before any real issues could arise.
However, I also stress that the 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 start when the reversionary beneficiary becomes the recipient. In essence this might result in a few months’ “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 will mean an SMSF member might have slightly more time to seek advice and make decisions after the death of a loved one.
