Should you segregate assets in your SMSF pension or not?

So, you’re setting up a pension in your SMSF. Richard Livingston examines whether you should segregate your assets and what steps to take.

Key Points

  • Funds moving to pension mode must choose between segregating assets or not
  • Segregation ‘promoted’ as a method to reduce tax, but costs often outweigh benefits
  • Unsegregated is likely to be the better approach for many but note exceptions

The time has come to switch your SMSF to ‘pension mode’ by taking a transition to retirement (TTR) or account-based pension (ABP). If your fund has more than one member, one of the first questions you’ll face is whether you should segregate the assets in the fund.

What is segregation?

When the first member starts taking a pension the fund will end up with both accumulation and pension accounts. Since the tax treatment of each type of account is different – income relating to pension accounts is exempt from tax and income for accumulation accounts isn’t – there’s a need to work out what belongs where.

This can be done through one of two approaches:

  1. Segregated. Here the fund is effectively dividend into two (or more) with assets allocated to each of the different types of account (or to a particular member’s account). The account to which assets belong is clearly identified and the returns (or losses) on these assets are credited or debited against that account.
     
  2. Unsegregated. If the fund’s assets are left unsegregated they continue to be run as a single pool (as they are during the accumulation phase). Since no asset belongs to a particular account, the fund’s overall income is allocated (by an actuary, at year end) between exempt and taxable.

What’s the benefit?

In the case of the common two-member, married couple SMSF, the fund’s assets are generally regarded as being for the benefit of both members equally. In this case, the main benefit of segregation is to get a better overall tax result.

Segregation allows assets with large unrealised gains (or high taxable income generally) to be allocated to the pension account, exempting the income from tax. So, in a situation where some of the assets have the potential to generate a high proportion of the fund’s overall taxable income there can be a benefit to segregating them.

But it’s important to remember that SMSFs don’t pay much tax anyway (on capital gains they effectively pay 10%, where assets are held for more than 12 months). Plus, the actuarial approach used when a fund is unsegregated typically exempts a large portion of the fund’s income (assuming the pension account is of a similar magnitude, or larger, than the accumulation account). So in the overall wash up, the benefit of segregation may not be that much.

Where a SMSF consists of members with different objectives (for instance, parents and children) then segregation can be a necessity, since it allows the results from particular assets to be allocated to the appropriate account.

Should I segregate?

In most cases, the answer is ‘no’. Extra tax benefits are a nice idea, but they’re often swamped by the administrative complexity and costs of running a segregated SMSF.

Running two or more SMSFs simultaneously increases the chance of mistakes and administration expenses. If you’re using a small accounting firm, relying on manual processes, you’ll probably be charged $300 to $1,000 extra each year. If you use an online administrator you might be charged only slightly more (or, in some cases, the same) but note also that some of the low-cost providers actively discourage users from this path.

If you segregate, when a pension is commenced, we recommend changing the account details (or ownership title) of every asset allocated to the pension account. That means you’ll end up with two of all of your investment accounts, including bank accounts and you’ll need to keep a close eye on what gets paid to, or comes out of, each.

Whilst the Tax Office has indicated that a segregated fund can operate a single bank account (see Tax Determination TD 2014/7), divided into notional ‘sub-accounts’ through careful record keeping, our advice would generally be to just keep two accounts. Unless you’re using top-notch software there’s too much risk of error.

Running an unsegregated fund entails obtaining an actuarial certificate each year but that’s a simple, inexpensive exercise. Services like Bendzulla Actuarial charge less than $200 to provide a certificate and have largely automated the process.

Finally, for some funds segregation just won’t practically work. If a fund has most of its assets invested in an indivisible asset like a property, the pension member’s balance often won’t be high enough to allow the asset to be segregated.

Even if it is, indivisible assets can’t be sold in small parcels, so the fund can often run into liquidity problems and be unable to make minimum pension payments or simply pay its bills. Remember, if a fund is segregated, cash in the accumulation side of the fund can’t be used to pay super pensions.

When should I segregate?

Most SMSF trustees will be better off remaining unsegregated, although not always. So, when should you consider a segregated approach?

Firstly, when the tax benefits of segregating stack up against the cost, hassle and risks. Take, as a simple example, a fund with two members – one in pension mode and one in accumulation – whose balances are equal. Let’s assume that it’s invested across two asset classes – shares and term deposits – with $1m in each and the shares originally cost $500,000.

The fund has two choices:

  1. Keep the fund unsegregated. In this case each asset class is effectively half tax exempt, half taxable.
     
  2. Segregate the fund. If the fund is segregated the shares would probably be allocated to the pension account, making the dividends and capital gains completely tax exempt. But the interest on the term deposits would be fully taxable.

Let’s now assume the fund wishes to sell the shares in one year. Table 1 shows the approximate tax payable under each approach. In this case, with a very large unrealised gain (relative to the size of the fund) there’s some merit in going down the segregated path.

  Unsegregated Segregated
Table 1:- Tax payable under segregated and unsegregated approaches
     Accumulation   Pension 
Assets:      
 - Shares  1,000,000    1,000,000
 - Term Deposits  1,000,000  1,000,000  
Income:      
 - Dividends  40,000    40,000
 - Capital Gains (1)  333,333    333,333
 - Interest  40,000  40,000  
Total income  413,333  40,000  373,333
Allocation to exempt (2)  206,667    
(Unsegregated)      
Taxable income  206,667  40,000  -  
Tax payable  31,000  6,000  -  
       
Notes:      
(1) Where asset held for more than 12 mths, only two thirds of total gain is taxable.
(2) Estimate only. In real life the exempt income will be determined by an actuary.

Just keep in mind that the Tax Office (in withdrawn Draft Tax Determination TD 2013/D7) held the view that they could apply anti-avoidance rules where segregation is done primarily for tax purposes. So in deciding to take a segregated approach (and documenting it) tax should be a background factor, not the driving force, and it should be done well in advance of large disposals.

Remember also that shares, property and other growth assets are often held for a very long time and sold gradually. So whilst we’ve done our calculations on the basis of a large one-off capital gains saving, in real-life it’s likely to happen in dribs and drabs, if at all.

Don’t forget either that the accumulation member will move into pension phase at some point. If that time’s not far off, consider remaining unsegregated and waiting until then to realise large gains. If all members are in pension phase, the entire fund is effectively tax exempt.

The other main situation where SMSF trustees should segregate is when the members have different investment profiles. For example, if you have a ‘family fund’ with a property that ‘belongs’ to mum and dad and a share portfolio managed by the kids then segregation allows you to match up the members with ‘their’ assets.

In this case, segregation doesn’t really add an extra burden, but simply reflects the added complexity and cost of running a mixed purpose SMSF.

How to segregate

If you choose to remain unsegregated, there’s not really anything you have to do (apart from remember the annual actuarial certificate). But if you choose to segregate, you’ll need to take action.

First, review your trust deed. If it sets out rules for segregating assets make sure you follow them. If the trust deed is silent the key points to remember are:

  1. Investment strategy. The investment strategy needs to have a ‘sub-strategy’ for each segregated account (or member, if you’ve segregated by member) and you need to make sure they match what happens in real life.
     
  2. Complete separation. Your two (or more) pools of assets need to be completely separate. As we indicated above, this means assets like property and art need to be allocated entirely to one account or the other (note though that this is the Tax Office’s view and hasn’t been tested in court). For shares, you’ll need to have at least two brokerage accounts (for example, ‘Smith SMSF – Pension A/C’ and ‘Smith SMSF – Accum A/C’) and (as mentioned above) we suggest doing the same with your bank account(s). If the fund has more than two members and you want to allocate investments to the accounts of particular members, you’ll need to go a step further. Instead of just allocating between pension and accumulation you’ll need an investment account for each member, with a designation along the lines of ‘Smith SMSF – PSmith A/C’.
     
  3. No mixing. Payments and receipts need to come from, or go into, the right account. If a dividend is paid on shares allocated to Peter, then the cash needs to end up in the ‘Smith SMSF – PSmith A/C’. Similarly, Peter’s pension payments need to come from this account. This is an area where it’s easy for mistakes to occur. Joint expenses like audit fees need to be apportioned between the accounts and paid from each bank account separately.
     
  4. Segregation needs to be documented. If you choose to segregate, you’ll need to document it in the trustee minutes. For each investment you’ll need to say something like ‘5,000 TLS shares purchased on ’x date’ are to be allocated from 1 July 2014 to fund Peter’s pension only’. (We said it wasn’t easy!) Problems can arise where you want to allocate parcels of shares as you need to indicate which specific parcels fund each account.

You’ve probably got the impression that we don’t believe in segregation. The truth is simply that it’s done too often and very few funds get it exactly right. As technology and data mapping improve, the cost and risk associated with segregating assets is likely to fall, so don’t be put off if segregation makes sense for you. Just make sure you discuss your intended strategy with your administrator before implementing it.

The choice to segregate or not can be a complicated one that’s highly dependent on your personal situation. If you’re unsure we recommend seeking personal advice but we’re also happy to answer your questions via the Q&A function.

Richard Livingston and Liam Shorte are founders of Eviser.

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