The capital gains tax-free status of superannuation funds in pension phase looks safe for now, but the government's decision to leave the political hot potato on hold will not ease the fears of self-funded retirees.
Super is tax-free once members turn 60 and retire, but it is the potential for large tax-free capital gains that has attracted Treasury's attention, especially now that self-managed super funds (SMSFs) are allowed to invest in property.
In 2010, Treasury famously referred to SMSFs as the new tax-minimisation vehicle of choice.
While super funds pay capital gains tax at concessional rates on the disposal of assets during the accumulation phase, all income is tax-free in the pension phase, including income from the sale of investments.
The technical director of the SMSF Professionals' Association of Australia, Peter Burgess, says it has been incorrectly reported that there is an anomaly in the system that allows only SMSFs to shift investments from the accumulation phase to pension phase without paying capital gains tax.
"This is not the case," he says. "It applies to all super funds but a lot of large funds use [the shift to pension phase] as a capital gains tax event. The law does not require them to do that but for administration purposes they may choose to do so."
Beyond the grave
Burgess argues that any move to treat the transfer of assets into a super pension as a disposal for tax purposes would not help the budget position or bring in additional revenue.
"A lot of funds are sitting on large unrealised capital losses as a result of the global financial crisis," he says. "Funds could use this to offset capital gains so revenue would be minimal. If they keep changing the rules, it dents confidence in super and people may turn to holding assets outside super, which is not as heavily regulated."
While capital gains are tax-free while retirees draw a pension, this preferential treatment does not necessarily extend beyond the grave.
In a controversial draft ruling last year, the Australian Taxation Office ruled that when members die, their fund ceases to be a pension and all underlying assets must be sold to fund their death benefit. This means the fund loses its ability to sell investments on a tax-free basis.
Instead, capital gains will be taxed at a rate of 15 per cent if held for less than 12 months and 10 per cent if held for longer.
This can result in a large unexpected tax bill for the member's beneficiaries where assets have been held for a long time.
The exception to this rule is where the deceased has what is called a reversionary pension. A pension can only be reverted to a spouse and this allows them to continue receiving pension income with the capital gains tax exemption intact.
Confusion about capital gains tax rules and how they are applied when someone dies is widespread. A senior adviser for Donnelly Wealth, Russell Lees, says clients often want to know if the estate will be hit with a capital gains tax bill when assets are sold and, if so, who foots the bill.
When people die, their assets are distributed according to their will. If shares, property or other investments held outside super are sold and the proceeds distributed in cash to their beneficiaries, then normal capital gains tax rules apply. Realised capital gains must be included in the deceased's final tax return and tax paid at their marginal rate.
The family home remains tax-free provided it is sold within two years.
However, Lees says assets such as shares or property can be transferred into the name of a beneficiary with the original cost base intact, and capital gains tax deferred until they sell the assets.
The one exception is assets purchased before September 1985, whereby the cost base becomes the market value at the time of death.
But things become more complicated if the assets are held inside a super fund, especially when the fund is already in pension phase.
Reversionary pension
"It pays to have a reversionary pension," Lees says. Failing that, he says, people should consider selling down assets with large unrealised capital gains while they are alive and their fund is still tax-free.
Not doing so can produce a double blow for a surviving spouses who receive a lump-sum death benefit and want to put it back into a tax-free super pension.
Not only will they be liable for capital gains tax, but if the lump-sum benefit exceeds their annual contribution cap they may have to drip-feed the cash back into super over several years.
Lees says the situation is even worse when a super lump sum is paid to an adult child who must also pay death benefits tax of 15 per cent on the taxable component of the account balance. (Death benefits paid to a surviving spouse or financial dependant are tax-free.)
Burgess says Treasury has been listening to the industry's concerns about the ATO draft ruling affecting the treatment of capital gains in pension accounts on the death of a member.
"One option Treasury is looking at is considering a fund as a pension until six months after death," he says. This would give funds time to sell assets supporting the pension death benefits and pay the proceeds out to beneficiaries while they are not subject to capital gains tax.
The final ATO ruling is overdue, which makes Burgess think it's likely Treasury is planning to adopt the six-month rule.
How capital gains tax works
Capital gains taxwas introduced by the Hawke-Keating government on September 20, 1985, and applies to all assets acquired on or after that date.
Notable exceptions are the family home and assets held in a super pension.
Capital gains tax is paid at your marginal rate on any net profits you make from the sale of assets, or at the concessional rate of 15 per cent for investments held
inside super.
Net profits, or capital gains, must be included in your income tax return for the year in which they were made. Your net capital gain is total capital gains minus any capital losses, including unused net capital losses brought forward from previous years. If you hold assets in your name for at least 12 months before selling, then any capital gain is discounted 50 per cent. In otherwords, you only pay tax on half your profit. This means that someone on the top marginal tax rate of 46.5 per cent
pays an effective 23.25 per cent tax on capital gains. If assets are held inside super
for more than 12 months, the discount is 33.33 per cent before tax is payable at the
superannuation rate of 15 per cent. This results in an effective tax rate of 10 per cent (66.66 per cent of 15 per cent). Once the fund is in pension phase, all capital gains are tax-free.
Frequently Asked Questions about this Article…
How does capital gains tax (CGT) apply to superannuation funds in pension phase?
Once a member turns 60 and the fund is in pension phase, income including capital gains from the sale of investments is tax-free. By contrast, assets sold during accumulation are subject to concessional rates inside super (15% tax with a 33.33% CGT discount for holdings over 12 months, producing an effective rate of about 10%).
Do self-managed super funds (SMSFs) have a special advantage to avoid CGT when shifting investments into pension phase?
No. The ability to move investments into pension phase without triggering a CGT bill applies to all super funds. Peter Burgess of the SMSF Professionals’ Association explains that some large funds simply treat the shift as a CGT event for administration reasons, but the law itself is not limited to SMSFs.
What happens to a super fund’s CGT status when a member dies?
Under a controversial ATO draft ruling, when a member dies the fund may cease to be a pension and underlying assets could be treated as sold, attracting CGT (15% for assets held under 12 months, 10% for assets held longer). That can create an unexpected tax bill for beneficiaries unless an exception applies (for example, a reversionary pension).
What is a reversionary pension and why does it matter for CGT and beneficiaries?
A reversionary pension lets a pension continue to a spouse after the member’s death. If a pension properly reverts to an eligible spouse, the fund can retain its pension-phase status and the capital gains tax exemption remains intact—avoiding the possible CGT hit that can arise if the fund is treated as having ended on death.
How can beneficiaries be hit with CGT when inheriting assets, and are there ways to defer tax?
If assets are held outside super and sold after death, normal CGT rules apply and gains must be included on the deceased’s final tax return. Assets transferred directly to a beneficiary can keep the original cost base so CGT is deferred until the beneficiary sells. The family home is generally CGT‑free if sold within two years, and assets bought before 20 September 1985 use market value at death as the cost base.
What practical steps can retirees take now to reduce the risk of a big CGT bill for their estate?
Advisers in the article recommend considering a reversionary pension for a spouse and thinking about selling assets with large unrealised capital gains while you’re alive and the fund is tax‑free. Planning can also avoid forcing survivors to exceed contribution caps when returning lump‑sum death benefits to super.
Is Treasury planning to change the way CGT is applied to pension accounts after death?
Treasury has been listening to industry concerns and is reportedly considering treating a fund as a pension for up to six months after death. That approach would give funds time to sell assets and pay death benefits without triggering CGT, and industry commentators think Treasury may adopt this six‑month rule.
How does capital gains tax work more broadly for everyday investors?
CGT in Australia applies to assets acquired on or after 20 September 1985 (with some exceptions such as the family home). For individuals, net capital gains are included in your tax return and, if held at least 12 months, you get a 50% discount on the gain. Inside super, the CGT discount is different (a 33.33% reduction with tax at 15% for long‑held assets), producing an effective 10% rate; in pension phase those capital gains are tax‑free.
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