A powerful pension top-up strategy

Changes to the law often mean the death to some strategies. But they can equally breathe fresh life into previously unloved strategies.

Transition to retirement (TTR), thanks to the taxation of TTR pension funds from July 1 this year, is one strategy whose star will fade dramatically under the new rules.

But if you're not familiar with the term 'partial commutation', then it's time to get your head around it.

A partial commutation is a lump sum payment from a pension income stream.

It is not, necessarily, a part of the pension paid from your pension fund. And this will become a critical difference for many, particularly those who are close to, or over, the $1.6 million threshold.

Where a pension is the payment of an income stream from a pension fund, a partial commutation is the payment of a lump sum from the fund that has the impact of reducing the asset base of the pension fund.

From July 1, partial commutations will become an integral part of many superannuation fund income strategies, for those who need more income than just the minimum pension payment requirement.

Why?

Because while a pension payment has no impact on the size of your personal transfer balance account (TBA), a partial commutation reduces it directly.

For example, if you are 65 and have transferred $1.6m into your TBA, you will be required to take a 5 per cent pension. That's $80,000.

At age 65, you can gain full access to your super. It becomes unrestricted, non-preserved. So, technically, if you need more income, you can grab whatever you need from your super fund.

But here's why you should probably take a partial commutation instead of just drawing further income from your fund.

A 'partial commutation' will have the added benefit of providing a 'debit' to your Transfer Balance Account.

That is, if you have taken your minimum pension (on $1.6m, of $80,000), but need further income of $100,000, then taking a partial commutation for that sum will have the impact of reducing your TBA by $100,000, from $1.6m to $1.5m.

Why is this important?

Because you could, then, in the future, effectively put another $100,000 back into your pension fund.

See my example below.

The withdrawal via partial commutation acts as a debit against your TBA total.

The advantages, obviously, are that the sum is taken as a tax-free amount from your pension fund. While some clarification is still being sought/given from the Tax Office via an explanatory memoranda, it is expected that pension funds will still be able to make partial commutations.

Where does the benefit lie?

I'll illustrate this by way of example.

Let's take a 65-year-old who currently has $2m in pension. On July 1, they will have to transfer $400,000 of that out of the pension fund to meet the transfer balance cap requirements, which limit pension funds to $1.6m.

And let's say that they choose to put that back in accumulation (rather than take the $400,000 out of the super system, where it would become subject to marginal tax rates, of between zero and 49 per cent). If left in the super system, that $400,000 will be subject to income tax at 15 per cent on future earnings.

Between age 65 and 75, our member would have to take a minimum pension of 5 per cent each year of the June 30 balance from the previous financial year.

For simplicity's sake, they are drawing 5 per cent, but the fund has only been earning 5 per cent, so they are roughly drawing what the super fund is earning (ignore how bad that sounds as a return on your investment for the purpose of this exercise).

The member's income needs are greater than the 5 per cent pension payment. In fact, they are double. They need approximately $160,000 to live on each year.

If they took the amount as pension payments, their super fund would reduce to the tune of an extra $80,000 a year.

If they were, instead, to take the extra $80,000 as a partial commutation, their overall pension fund balance would still be reduced to the tune of $80,000 a year.

However, by taking a pension, their transfer balance account, which started at $1.6m, would still be sitting at $1.6m.

If they took the extra $80,000 a year as partial commutations, they would, instead, have decreased their TBA by $80,000, from $1.6m to $1.52m. Over five years, this would reduce the TBA by $400,000 (5 x $80,000).

The member would then be able to use another $400,000 from their accumulation fund to top up their pension fund account balance.

The rules surrounding this strategy are still far from perfectly clear. But the broad strategy seems to be locked in, based on what the ATO has said in explanatory memoranda, to this point.

But keep an eye on this strategy. I will keep you updated in the months to come.

The information contained in this column should be treated as general advice only. It has not taken anyone's specific circumstances into account. If you are considering a strategy such as those mentioned here, you are strongly advised to consult your advisor/s, as some of the strategies used in these columns are extremely complex and require high-level technical compliance.

Bruce Brammall is a licensed financial advisor, a mortgage broker and an expert on self-managed super funds. He is a regular contributor to Eureka Report. To contact Bruce, please click here.