SMSF Strategy

Pension Phase – to segregate or aggregate?

The decision of a member to move from accumulation to pension phase provides significant tax advantages not only on what is drawn down by the member as an income stream (e.g. 60+ tax free), but also provides a tax exempt status on income generated from assets funding the pension.  This is particularly attractive as it provides fund trustees the ability to realise capital gains on assets without paying CGT (as capital gain in exempt).

As part of the decision to move to pension phase, a decision needs to be made regarding the existing composition of the fund assets in so far that whether particular assets of the fund are to be segregated to the pension account of the member, or alternatively retain all assets of the fund in a pooled environment (unsegregated).  Where the decision is to have investments pooled, an actuarial tax certificate may be required to determine the total pension liabilities as a percentage of the total fund liabilities (i.e. total balances of the fund).

Where a decision is made to segregate assets, there are two alternatives as to how segregation may apply.  Firstly, particular assets may be specifically allocated to a member, that is for example, John who is starting a pension decides to segregate the BHP shares in the Fund to his pension account.  The second method is to create segregated ‘pools’, whereby specific assets are allocated to all pension members (as opposed to the accumulation members).  For example, the SMSF may have four members, John (Dad), Gail (Mum), Tom (Son) & Cate (daughter); John and Gail are drawing pensions, with Tom & Cate in accumulation phase.  Specific assets can be allocated to a pension pool for the benefit of John and Gail, and vice versa.  This way, both pension members can enjoy the net earnings of the allocated fund investments without specifically allocating individually to each pension member.

So, what are the reasons as to why someone may segregate vs. aggregate (pool)?

Reasons to segregate assets

  • Wish to realise an asset with significant capital gains tax. Where transferred into the pension account, the capital gain is exempt (tax-free).
    • Example – an SMSF bought a residential property in 2003 for $350,000.  Today this property is worth $650,000 and the trustees have decided to sell the property as they are moving to pension phase and require greater liquidity.  If the asset is sold in accumulation phase, the capital gain of $300,000 is taxed @ 10% (1/3rd discount applies as held >12 mths) = $30,000 tax.  If sold after having commenced pensions, the CGT = $0, as the capital gain is exempt from tax!!
  • You have a combination of pension and accumulation members or interests. You have the ability to include the higher income producing assets into the segregated pension account, and the lower income (higher capital growth assets) or tax deferred income in the accumulation account.
    • Example – ABC Super Fund has four family members – Dad, Mum, and two kids.  Mum & Dad are drawing pensions.  The portfolio has a combination of shares, property trusts and managed investments.  The trustees decide to segregate the high yielding shares to the pension ‘pool’ with the listed trusts to the accumulation ‘pool’, as the majority of the income was tax-free or tax-deferred.  As a result of segregating this way, the fund will end up with very little taxable income.
    • Note – if you are running a gearing in super strategy that includes pension members, it is important to segregate the geared asset into the accumulation portion of the fund if you want to have the interest expense as deduction to the fund (otherwise the expense will be exempt, that is non-deductible).

Reasons to have an unsegregated strategy

  • It’s simple. Many SMSFs are setup simply because Mum and Dad (potentially along with the kids) which to ‘pool’ their money and make investment decisions as a family.  These investments decisions may be across a broader range of assets (e.g. shares), or in a single investment (e.g. property)
  • When paying out a death benefit where there are no longer any dependant beneficiaries. Superannuation and tax law outlines that where there are no longer any dependants that are able to receive an income stream, the fund goes back to accumulation phase (to read more, refer to blog on “Intergenerational SMSFs“).  Where the fund is segregated to a member, the full unrealised value of the investments would be subject to CGT at 10% (assume 1/3rd discount applies).  Where the assets remained pooled, an actuary would be engaged to provide a level of tax exemption for the financial year, which would include CGT.
    • Example – Vin (82) was receiving an account based pension and passed away on 31 March 2009.  His account balance was $800,000 (total fund = $1m).  The cost base on the $800k of assets was $400,000.  His nominated beneficiaries were his adult children (no dependants) who were also fund members. Vin’s benefits were transferred to the estate on 31 May 2009. Where the assets are segregated to Vin’s account, there will be a capital gain of $400,000 taxed at 10% = $40,000 tax.  Where the assets remain unsegregated, an actuary would determine that approximately 9/11ths of all fund income (including CGT) would be exempt for the financial year.  This would mean that only 18% of the capital gain ($72,000) would be taxed at 10% = $7,200.  This provides a tax saving of $32,800!!

Note: where all members (superannuation interests) are in pension phase, it is considered for tax purposes that the fund is 100% segregated, regardless of whether there are segregated assets to a particular member.

It is important to remember that the decision to run segregated or unsegregated investment strategies is at the absolute discretion of the fund trustees.  What trustees need to be aware of is that the investment strategy of the fund gives appropriate and ongoing consideration of decisions made regarding segregation and that changes are appropriately documented.

Most superannuation specific software can cater for both segregated and pooled investment strategies within an SMSF.  For an SMSF adviser, the development of a fund’s overall strategy will ultimately determine whether segregation will need to occur.

Whatever the strategy, it is important that trustees and advisers understand the merits of segregation and how it can add significant overall value to the fund and its members.

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