Increasing exempt current pension income percentage in your Self Managed Super Fund (SMSF)

Exempt current pension income (ECPI) is the amount of income that is exempt from taxation inside an SMSF.  An SMSF has exempt income if the SMSF has a pension or pensions that comply with the minimum pension standards each year. A fund can be 100% tax free if all members are in pension phase and the minimum pension/s for each member were withdrawn for the financial year that ECPI applies.

The tax exemption applies to all income (including capital gains) that is generated from the fund assets held to support retirement phase income streams. ECPI does not apply to non-arm’s length income a fund may receive or any concessional contributions.

For example, the Happy Days Superannuation Fund has two members both in pension phase in the 2018 financial year, no member has any accumulation balances and each member withdrew at least their minimum pension amount prior to 30 June 2018.  The fund did not receive any non-arm’s length income so all income received on the fund’s assets throughout the year would be 100% tax free.

Importantly if at any time the pensions for which the ECPI has been granted do not comply with pension standards (by withdrawing the minimum pension amount required), the SMSF will lose its exempt current pension income which may apply to the full financial year.

It is important to remember that if an SMSF has an ECPI amount, that only the taxable percentage of expenses can be used to claim a tax deduction.  For example, a SMSF has an actuarial percentage of 90%, the taxable proportion of the SMSF’s income is 10% and therefore only 10% of expenses can be deducted from the SMSF’s remaining income.  If the SMSF is 100% tax free, no expenses can be claimed because there is no income for the expenses to be deducted from.  Expenses cannot be banked or saved like capital losses.   So in 100% pension phase expenses cannot reduce taxable income.

When an SMSF has both pension accounts and accumulation accounts running at the same time, an Actuarial Certificate is required to confirm the correct tax free percentage of the SMSF’s income.

The Actuarial Certificate will take into account the timing and amount of every contribution, pension payment and any member transfer.

A higher actuarial percentage will result in higher ECPI and less tax to pay.

The timing of contributions and pension payments throughout the year can have an effect on the level of exempt current pension income (ECPI) an SMSF can claim in a particular year.

For those that are eligible to make concessional or non-concessional contributions into super post retirement, the ECPI percentage is reduced the longer the period of time that contributions are held in a member’s accumulation account.

The actuary requires details on when members benefits are paid, whether they are pension payments or lump sums and whether these are paid from a member’s pension account or a member’s accumulation account.

For example: A SMSF with a sole member aged 63 years of age who has met a condition of release, has $1.6 million in pension phase and $400,000 in accumulation phase.  The member is seeking to draw an annual income stream of $80,000 while the net earnings of the funds was 6 per cent per year. Note that the minimum pension requirements for someone aged under 65 years of age with $1.6m in pension is $64,000 ($1.6m x 4%)

If the member drew down his / her $80,000 income stream monthly by exhausting the minimum pension payment requirement first and then sourcing the rest of the payments from his / her accumulation account as lump sums, an estimated ECPI of 74.65 per cent would apply.

If however monthly income payments above the required 4 per cent minimum pension payments were made by lump sums from the accumulation account first, with the remaining payments subsequently made from the pension account, the ECPI increases to approximately 80.32 per cent because more money is retained in the pension account for a longer period and the accumulation account is reduced sooner.

If you are seeking to draw out more than the minimum pension required for a financial year, you need to have met a condition of release and ensure the funds deed and ATO compliance documentation is in place. Please speak to our Superannuation Manager Helen Cooper for more information.

Any information provided in this article is general in nature and does not take into account your personal objectives, situation or needs. The information is objectively ascertainable and was not intended to imply any recommendation or opinion about a financial product. This does not constitute financial produce advice under the Corporations Act 2001.

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Division 7A

Division 7A is an area of tax law often mentioned and worried about by accountants and tax advisors, but generally not well understood by business owners. The legislation broadly covers the use of company money by shareholders without first declaring a dividend and was introduced in December 1997. Balances arising before this date are excluded from the measures.

Under the legislation amounts ‘borrowed’ from the company and used by shareholders for private purposes are deemed to be an unfranked dividend. This is obviously undesirable as it increases the taxable income of shareholders and simultaneously denies them the benefit of franking credits that could have accompanied a franked dividend.

Fortunately, the legislation also includes a mechanism whereby borrowed funds can be placed on a complying loan agreement, colloquially referred to as a “Division 7A Loan” or “s109N Loan”. Loans are principal and interest and can be in place for 7, 10 or 25 years.

In December 2009 the impact of the legislation was extended by the ATO to also cover unpaid trust distributions to companies, however these amounts could be placed on more flexible 7 or 10 year interest only loans. Again, balances that arose prior to December 2009 were excluded from the measures.

In both cases we have managed these ‘loans’ for our clients with an emphasis on smoothing and planning income levels each year while still complying with the requirements of the legislation. Generally, this is done through the declaration of dividends each year which are applied against the outstanding balances. This all appears about to change though as the Government flagged in the May budget that they intend to implement changes to Division 7A in line with recommendations from the Taxation Review Board.

The Government are yet to table any legislation on the matter but is expected that the following key changes will be made:

• Interest only loans will no longer be an option, all loans will be principal and interest with repayment benchmarks
• 7 and 25-year loans will no longer be an option and, of most concern,
• Amounts previously excluded as being pre-December 1997 and pre-December 2009 will now be caught by Division 7A

For these reasons we are seeking to proactively manage excluded amounts on our clients’ balance sheets as part of our compliance program in 2018. This approach will be most noticeable for clients with large balances currently excluded by the legislation. We believe that by addressing these issues sooner rather than later we can avoid sudden, large increases in tax that our clients have not planned for.

If you are concerned about your own Division 7A exposure or have friends and family who you believe are not being correctly advised in this area, we encourage you to contact us as soon as possible to discuss the above. For the vast majority of our clients there will be no noticeable change in the strategy for managing your tax affairs.

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