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Meg on SMSFs: Is it better to wait until July to start your pension?

In a monthly column to assist trustees, specialist Meg Heffron explores major issues on managing your SMSF.

There has been plenty of media over the last few weeks about the fact that the 'transfer balance cap' will increase to $1.9 million from 1 July 2023.

This is the limit on how much anyone can put into a super pension after they retire. It started at $1.6 million in 2017 and increased to $1.7 million in 2021. The next leap will be to $1.9 million but only those who don’t start any pensions until 1 July 2023 receive the full increase. Someone who starts a pension now and uses up their full limit of $1.7 million won’t see any increase in July.

So many retirees with high super balances who were about to start pensions in their SMSFs are wondering if they should wait.

Weighing up various scenarios

Believe it or not, it depends.

One of the benefits of starting a pension as soon as possible is that the fund stops paying income tax on some or all of its investment earnings (dividends, rent, interest, capital gains etc).

Consider an SMSF with a single member, Joel, who has $2 million in super. Let’s say Joel started a pension on 1 February 2023 with as much as possible at the time, $1.7 million. At the end of the year, an actuary will work out what proportion of the fund’s investment income is exempt from tax in that first year. It’s likely to be around 35% of all the income it earned during 2022/23 (even the rent, dividends, interest, gains etc. that it earned before the pension started).

Note that next year the percentage will be even higher, around 85%. It’s lower in the first year to reflect the fact that the pension didn’t start until the year was well progressed.

If the pension doesn’t start until 1 July 2023, the SMSF (and therefore the member) will miss out on this tax break. So what is it worth?

That depends on how much income the fund earns in 2022/23. And remember we only look at the income that is taxed. The growth in the value of assets doesn’t count unless the assets are sold because only realised capital gains are taxed.

Let’s say Joel’s SMSF earned $100,000 in rent, interest, dividends etc. during 2022/23. This equates to 5% of its assets. If Joel’s pension started on 1 February 2023, the fund skips paying tax on 35% of this, or $35,000. As super funds pay tax at 15%, the value of the tax break is 15% x $35,000, i.e. $5,250.

On the flipside, what would be gained by waiting for the transfer balance cap to go up before starting the pension?

Joel will put an extra $200,000 into his pension and it will start at $1.9 million rather than $1.7 million. That means in future years the fund will receive an even higher tax break on its investment income.

For example, if the pension started at $1.7 million in 2022/23, the SMSF will be able to treat around 85% of its income as exempt from tax in 2023/24. It would be closer to 95% if the pension started at $1.9 million on 1 July 2023.

So what’s that worth?

If we assume that the fund earns about the same taxable investment income in 2023/24 (say $100,000), the benefit of waiting is around $1,500. I worked this out by saying: the fund can treat an extra 10% (95% - 85%) of its income as being exempt from tax (10% x $100,000 is $10,000). Since super funds pay tax at 15%, Joel’s fund will save $1,500 (15% x $10,000) in the first year if he doesn’t start his pension until 1 July 2023.

Then some saving like this will happen in every subsequent year. If we wait long enough, it’s highly likely that waiting will be a better option.

But a few points leap out.

Firstly, the saving is quite small. So those who started their pensions in 2022/23 need not feel they have made a tragic error. Even if we model for five, 10 or 15 years into the future allowing for variables that impact the calculations (for example, future investment returns, pension drawings, inflation and more), waiting is better by thousands or tens of thousands of dollars but not hundreds of thousands.

Secondly, it will take three to four years before the savings from waiting until 1 July 2023 add up to more than the savings from starting on 1 February. A lot could happen in that time.

Other things to consider

In this comparison, we’re looking at someone starting a pension in February with five months left in the current financial year and a high percentage of tax-exempt income (35%). As we move closer to the end of the year, the decision will be easier - waiting until July will be better. That’s because the actuarial percentage is lower if the pension doesn’t start until later in the year. Someone starting in June, for example, will have virtually none of the fund’s income treated as being exempt from tax in 2022/23. They have nothing to gain by starting early.

It depends on how much taxable income the fund earns this year versus next year. What if this SMSF had sold a large asset and made a big capital gain in 2022/23? Perhaps the fund’s taxable investment income is normally around $100,000 but this year it will be $300,000? In that case, the member should probably start their pension as soon as possible to make sure that 35% of $300,000 ($105,000) is exempt from tax, saving $15,750 in 2022/23. If the fund’s income reverts to normal in the subsequent years, it will take many years of $1,500 savings to make delaying more attractive.

Overall, I would say that – all other things being equal – waiting is probably better but not by as much as it might appear. Certainly, it will take a while to feel that way and it’s worth doing the calculations to be sure.

 

Meg Heffron is the Managing Director of Heffron SMSF Solutions, a sponsor of Firstlinks. This is general information only and it does not constitute any recommendation or advice. It does not consider any personal circumstances and is based on an understanding of relevant rules and legislation at the time of writing.

For more articles and papers from Heffron, please click here.

 

5 Comments
mp
February 20, 2023

Hi Meg, would you be kind to enlighten, pls.tq. I am the sole member of my smsf. I am in my 60s and I am working part time as I am still enjoying my work. Because of my wages from part time work and savings outside of smsf, I dont presently need to start a pension. I would exhaust my savings and wages before starting this pension. Is there a dateline for my smsf to start paying me pension ? Shd I start this pension, what is the legislated minimum pension payment per year ? Once this pension is started, the payment cannot be paused for any given year ?

Mark
February 18, 2023

Hi Meg, the calculations are definitely worth doing. They are particularly relevant when also using the re-contribution strategy to impact the tax free % for the member given that it would allow another $440K of NCCs to be ploughed into the fund over a relatively short period (current TSB allowing) since the relevant caps to allow contributions will also be increasing on 1 July.

Ant
February 20, 2023

Is this increase of caps true? They are linked to wage increases not CPI.

Mark
February 22, 2023

Hi Ant, the $440K is made up of $110K before June 30 followed by $330K next year using the 3 year bring forward rule. I’m presuming this is what you are referring to. The amounts are linked to wage increases as you suggest.

Jack
February 16, 2023

Thanks, Meg, I had not thought through how there are examples of where it might be better not to wait.

 

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