Commencing a Pension in your SMSF

When you reach aged age 55 you have the option of commencing a Pension Income Stream from your SMSF.  A Pension simply means that periodically (eg each month or other period you nominate) cash is transferred from your SMSF Bank Account to your personal Bank Account to fund your living expenses.  The Benefit in commencing a Pension in your SMSF is that after commencing a Pension you will never pay tax on the SMSF income (eg interest and dividends) and realised capital gains made by your SMSF again.  This is truly an amazing taxation concession and makes commencing a Pension in your SMSF the perfect investment vehicle to hold your assets.

Pension Types

There are two types of Pensions you can commence in a SMSF as follows:

Simple Account Based Pension:

A Simple Account Based Pension is an income stream that you receive from your SMSF when you reach age 65 or alternatively when you are aged between 55 and 64 and "Retired".

Transition to Retirement Pension (TRAP):

A Transition to Retirement Pension (TRAP) is an income stream that you receive from your SMSF when you are aged between age 55 and 64 and NOT "Retired". 

Which Pension should you commence?

This issue is typically confused by clients.  In reality there is really no choice.  If you are over 65 or you are aged between 55 and 64 and are "Retired" you can only commence a Simple Account Based Pension.   If you are aged between 55 and 64 and are NOT "Retired" then you can only commence a Transition to Retirement Pension (TRAP).  Therefore in order to determine which Pension to commence the definition of "Retirement" is important and the definition will vary depending on when you cease work.

If you cease employment after age 60, "Retirement" means you simply cease your employment.  In this case the intention to return to the workforce is irrelevant.  This means that you can essentially return to work soon after ceasing your employment after age 60, but you will still deemed to be retired and able to commence a Pension.  The definition of retirement in this case is less stringent than for those under 60.  A "Retirement" Declaration must be signed if you cease employment after age 60 and can be found here.

If you cease employment between age 55, "Retirement" means that at the time you ceased employment you never intended to work again either on a full-time or part-time basis (defined as more than 10 hours per week).  This declaration must be made to your SMSF and is made at the time you cease employment.  It is noted that whilst a person who ceases employment when aged between 55 and 59 never intends to work again, they may ultimately do so. This will not alter the person's status as being retired enabling them to have access to their Super Benefit notwithstanding they have returned to work.  A "Retirement" Declaration that must be signed if you cease employment aged between age 55 and 59 can be found here.

Benefits of commencing a Pension

There are several benefits in commencing a Pension from your SMSF.  The obvious benefit is that you are able to commence accessing your Super Benefit after age 55 even if still working.  This will help with living expenses as and when they arise.  However this is not the main benefit of commencing a Pension in your SMSF.  The main benefit of commencing a Pension is that the SMSF tax rate effectively reduces to NIL for all income and realised capital gains made by the SMSF when you commence a Pension.  This means that all income and realised capital gains the SMSF derives after the Pension has commenced will be tax free.  A Pension is almost the perfect investment vehicle in which to have your investments from a taxation and accessibility point of view.  Consider the benefits when you commence a Pension from your SMSF:

-You never pay tax on your investment's earnings in the SMSF (eg interest and dividends)
-You never pay tax on your investment's realised capital gains made by your SMSF.
-You receive a cheque from the ATO each year equal to any franking credits received by your SMSF.
-You can access any level of income from your SMSF subject to an aged based minimum amount.
-The Pension income you access is tax free if you are aged above 60.
-The Pension income you access is concessionally taxed if you are aged between 55 and 59.
-You do not have to change your SMSF Investments when you start a Pension.

Taxation of Income and Realised Capital Gains in the SMSF

As detailed above the SMSF tax rate reduces to NIL on all income and realised capital gains made by your SMSF, when you commence a Pension. This means that all income and realised capital gains the SMSF generates after the Pension has commenced will be tax free.  This is a truly an amazing taxation concession and makes commencing a Pension in your SMSF the perfect investment vehicle to hold your assets.   Importantly any accumulated capital gains up to the time of commencing the Pension will also never attract tax if sold after the SMSF converts to a Pension.  For example assume you bought shares in the year 2004 for your SMSF and they increased in value by $100,000 by July 2011 when you commenced a Pension.  As long as you sell the shares after July 2011 when you commence the Pension you will never pay tax on that capital gain.  For more details click here.

Refund of Franking Credits

Given that there is no tax payable on SMSF income including dividends, when you commence a Pension you are entitled to receive any franking credits on Australian Share dividends in cash from the ATO.  Franking Credits simply represent tax paid by Australian companies on dividends your SMSF is receiving.  Given that the company has paid 30% tax and your SMSF tax rate on dividends is Nil when you commence a Pension, the entire 30% tax paid is refundable to your SMSF.  Example:  For every $10,000 received in fully franked dividend income, your SMSF receives $4,285 as a cash refund from the ATO each and every year the dividends are paid, after you commence a Pension!

Investments do not change

Nothing changes when you commence a Pension.  That is your investments stay as they are.  All that happens is that you execute documentation declaring that you wish to commence accessing your Super Benefit as an income stream.  Even better the documentation is prepared for you by ESUPERFUND when you are ready to commence your Pension.  For example if your SMSF owns cash and shares, then when you commence a Pension these assets stay as they are.  You do not need to sell the shares or transfer the cash to another account in the above example.  The only difference you will notice before and after commencing the Pension is that your SMSF will no longer pay tax on earnings and realised capital gains! 

Same Tax Benefits not available in Retail and Industry Superfunds

It is important to understand that the same tax benefits are not afforded to Retail and Industry Superfunds.  That is Retail and Industry Superfund's must take into account capital gains tax given that Members are entering and leaving the Fund continuously.  This means that the net returns credited to Members are net of realised or unrealized taxes.  Whilst a SMSF and Retail Superfund will both enjoy tax free status on income and capital gains after commencing a Pension, the accumulated capital gains tax up to the date the Pension is commenced can be eliminated in a SMSF.  This same tax advantage is not available in a Retail and Industry Superfund.

Pension & Salary Sacrifice Strategy

The effectiveness of a Pension Strategy is magnified when incorporated with a Salary Sacrifice Strategy after age 55.  This strategy basically involves you salary sacrificing as much of your income as you can afford (subject to limits) on one hand and on the other you receive a Pension income stream from your SMSF to help fund your living costs.  You can think of it as a "round robin" strategy where the money that is salary sacrificed is channeled back to you as a pension payment but in the process saving you thousands of tax dollars in tax.

The major problem with a Salary Sacrifice Strategy is that it considerably reduces the income you have to live on.  With a Pension Strategy this is somewhat mitigated as you can pay yourself a pension income from your SMSF softening the cashflow burden.  Importantly this maximizes the amount you can afford to salary sacrifice maximizing your tax savings leading up to retirement and giving you more in Super Benefits when you retire.

After the age of 60, implementing a Pension Strategy in combination with a Salary Sacrifice Strategy is truly a remarkable tax saving strategy because all pension payments are tax free after 60.  The tax saving benefits accrue on three levels.  The first is that you pay less tax on the salary you sacrifice.  The second is that you pay no tax on your SMSF investment income and realized capital gains.   The third is that there is no tax payable on the Pension you draw from the SMSF. 

Whilst it is true that commencing a Pension Strategy in combination with a Salary Sacrifice Strategy works best whilst you are working and are above 60 (when pension payments to you are tax free) it can still be a worthwhile financial exercise producing valuable tax savings if you are aged between 55 and 59.  This is because you continue save tax at the first two levels as detailed above.  However offsetting these tax gains is the tax that you pay on the Pension you draw from the SMSF (which we note is concessionally taxed and receives a 15% "Pension Rebate").  Overall the tax benefits can still be significant.  However this is not always the case.  It is possible because Pension payments are taxed that you can be worse off commencing a Pension and salary sacrifice strategy when under 60!  The results vary from person to person.

Case Study

To demonstrate the benefits of commencing a Pension and Salary Sacrifice Strategy whether you are Over 60 or Under 60, click here to view a Case Study.

Interactive Pension Analysis

To demonstrate the benefits of commencing a Pension and Salary Sacrifice Strategy using your own personal circumstances click here to participate in our Interactive Pension Analysis and see how much tax you can save.

Find out More

For more about Pensions click here.