There appears to be a great deal of mystery surrounding the use of reserves inside a SMSF. Whilst many thought the abolition of RBLs was the death of SMSF reserves, this is certainly not the case. For SMSFs, there are a range of strategies available that can utilise reserves to deliver exceptional client outcomes.
Section 115 of the Superannuation Industry (Supervision) Act 1993 allows for a trustee of a super fund to maintain reserves unless the governing rules of the fund prohibit their use. Section 52(2)(i) of the SIS Act also requires if the fund operates any reserves the trustees must formulate and to give effect to a strategy for their prudential management, consistent with fund’s investment strategy and its capacity to discharge its liabilities (whether actual or contingent) as and when they fall due.
I have outlined below 10 key things to know about using SMSF reserves:
- Your fund’s trust deed must allow for the creation and operation of fund reserves
- Need to develop a separate investment strategy for fund reserves
- Fund Reserves are built with investment earnings (can use insurance proceeds)
- Allocations from a reserve unless ‘fair and reasonable’ and less than 5% can count as a concessional contribution
- Can use contributions reserve to park money for up to 28 days after the end of the month in which the contribution is made(i.e. over a financial year)
- Anti-detriment Reserves
- Pension Reserves – allocate earnings to 100% TF pension
- Self insurance reserves
- Expenses reserve
- Proceeds of insurance policies can be directed to a Fund Reserve
Let’s take a more detailed look at each other these key issues:
1. Trust Deed
Before giving effect to any reserving strategies, it is important that the fund’s trust deed has been reviewed to ensure that it has the ability to create and manage a range of fund reserves.
2. Separate Investment Strategy
Superannuation law requires a fund that operates fund reserves to formulate a separate investment strategy. If a fund is running more than one reserve (e.g. investment reserve and anti-detriment reserve), the investment strategy may be used to be applied to all reserves or alternatively each reserve may have its own investment strategy.
It is most likely that the SMSF will be operating a segregated investment strategy or will have certain investments pooled to the fund reserves as part of the investment strategy.
3. Built with investment earnings
The development of any fund reserves within an SMSF is typically undertaken with investment earnings. Instead of allocating 100% of the net earnings to the members, the trustees can elect to retain some of these earnings and retain for purposes including anti-detriment, investment smoothing, and maintenance of income streams, etc. The 2009/10 financial year for many SMSFs will come back to positive returns in the fund after a horrendous few years on the share market. Many trustees will have an ability this financial year to consider retaining some of these investment returns.
4. Fair & reasonable allocations
With the introduction of contribution caps from 1 July 2007, section 292.25.01 was introduced into the Income Tax Assessment Regulations 1997, to effectively treat an allocation from a reserve as a concessional contribution for a particular member, unless the amount:
- is allocated in a fair and reasonable manner to every member; and
- the amount allocated is less than 5 per cent of a member’s account balance before the reserve amount is allocated
There are limited exceptions contained within section 292.25.01 where amounts will not be classified as a concessional contribution. These include:
- where an amount is allocated from a reserve used solely for the purpose of enabling the fund to discharge all or part of its liabilities (contingent or not), as soon as they become due, in respect of superannuation income stream benefits that are payable by the fund at that time, and
- any of the following applies:
- an amount has been allocated to satisfy a pension liability within the SMSF that was paid during the financial year;
- on the commutation of the income stream (except where the primary beneficiary dies), the amount is allocated to the recipient of the income stream, to commence another income stream as soon as practicable;
- on the commutation of the income stream as a result of the death of the primary beneficiary, and the amount is:
- allocated to a dependant beneficiary to payout the benefit (discharge fund liabilities as a result of the death); or
- where the above does not apply, is paid as a super lump sum and as a super death benefit as soon as practicable.
Examples here many include conversion of lifetime complying pension to market linked pension within an SMSF or simply where allocations are being made to an account based pension to support the required capital to meet the needs of the pension recipient. The ability to transfer pension reserves into a 100% tax free can be a very powerful strategy.
5. Contributions reserve
The use of a contributions reserve allows for a contribution to remain unallocated for up to 28 days before it is required to be assigned to a member. It is at this time that it becomes a contribution and counts against the respective contribution cap.
Contribution reserves are effective for a variety of reasons including:
- Making large contributions into super and spreading the contributions over 2 financial years For example, Mum & Dad want to make a $1.4m in-specie commercial property transfer to their SMSF. This can be achieved in June 2010 by:
- $150k each NCC contribution in 2009/10
- $50k each (over 50) as CC contribution in 2009/10
- remaining amounts held in contributions reserve
- on 1 July 2010, credit from reserve:
- $450k each as NCC contribution in 2010/11
- $50k each (over 50) as CC contribution in 2010/11
- Dealing with excessive concessional contributions where salary sacrifice has been restructured incorrectly. Refer to blog, “Help!! I’ve got excess contributions”
- Starting income streams with 100% tax-free component. For example, John makes $500,000 contribution into his SMSF, which includes $50k as a concessional contribution. John can allocate $450,000 as an NCC to his account and retain $50k in a contributions reserve. He can start a pension with the $450,000 as 100% tax-free component (assuming no other super interest within the fund) and then allocate the $50k contributions afterwards (within 28 days)
6. Anti-detriment Reserves
The operation of a Fund Reserve for the purposes of anti-detriment is probably the most commonly used within SMSFs (although reserves aren’t extensively utilised).
This ‘bonus amount’ or ‘tax saving amount’ paid as a result of the death of a member must typically come from fund earnings, as any additional amount paid (in excess of the deceased’s account balance) to a SIS dependent cannot be forfeited from another member’s account. Where this anti-detriment amount is paid to a dependant, the fund is entitled to a tax deduction in accordance with section 295-485 of the ITAA 1997.
There is currently some uncertainty with the use of anti-detriment reserves within SMSFs as the ATO’s current view is that any amount allocated credited from a reserve for the purposes of an anti-detriment augmentation counts as a concessional contribution. This view unfortunately puts SMSFs at a distinct disadvantage against other public-offer funds who typically use fund earnings to make these payments. I know that several submissions have been made (e.g. SPAA) in budget submissions, tax review submissions and also the Cooper Review about this inequity. Click here to read the NTLG Super Technical Sub Group minutes that discusses this issue.
Anti-detriment reserves can provide significant advantages in an SMSF for intergenerational wealth transfer including:
- ability to use the tax deduction to eliminate CGT on the sale of assets required to be sold or transferred within the SMSF where no tax dependants exist.
- ability to use tax losses from the deduction for next generation members to absorb these losses against concessional contributions and taxable earnings.
7. Pension Reserves
These type of reserves were common around in the form of solvency reserves for the payment of defined benefit pensions (e.g. lifetime complying pensions). However, the operation of pension reserves structured correctly can be a very powerful. Section 292.25.01 of the ITAR 1997 outlines that amounts allocated from reserves to satisfy a pension liability within the SMSF that was paid during the financial year do not count towards the concessional contribution cap.
The ATO confirmed their view of allocations to pension accounts from reserves in the NTLG Super Technical Sub Group meeting in September 2009. Their view supports the ability to transfer to a pension account, and that any allocation will be in the same proportion as when the income stream commenced. Therefore, this becomes a highly attractive as a strategy to consider allocating fund earnings to 100% tax-free component income streams (as long as it’s completed ‘fair & reasonably’).
8. Self Insurance Reserves
These type of reserves allow for the SMSF to use reserves to insure the fund members for salary continuance, life and total & permanent disability. The ability to provide these type of amounts would require sizeable reserve balances but allow for a tax deduction within the fund for the premium cost, which is determined by an actuary.
The ability to claim a tax deduction for life cover can run in conjunction with the use of an anti-detriment reserve.
9. Expenses Reserves
An expense reserve is a simple concept of maintaining capital for the ongoing payment of costs including administration, compliance , insurance and so on.
10. Directing Insurance proceeds to Reserves
Many SMSF deeds require life insurance proceeds to be credited to the deceased SMSF member’s account. This can prevent the use of reserves to potentially make an anti-detriment payment. An appropriately drafted trust deed should provide the trustees with discretion to be able to distribute the proceeds to Fund Reserves, which can then provide the trustees to determine the most appropriate strategies in respect to the payment of these proceeds to the fund members (being the potential beneficiaries).
Reserves can play an important role for any SMSF, whether it is to capture a contribution or be used as a powerful estate planning tool. The trust deed is the key to implementing a range of these reserving strategies, but you also need to be aware of the tax law overlay with allocations from reserves and the contribution caps. They do however act as an excellent tool to shift wealth across from generation to generation where managed effectively.