Two pensions better

PORTFOLIO POINT: Why take two pensions instead of one? Because the estate planning ramifications are potentially worth tens of thousands of dollars. Here’s why.

It can often make sense to start a pension well before you’re ready to retire.

The introduction of transition to retirement (TTR) pensions in 2005 meant many as young as 55 can be doing themselves a great service from a tax perspective by starting to draw a pension from their retirement savings while they are still working.

The advantages include a tax-advantaged (tax-free for the over-60s) income stream, making the earnings of your pension fund tax-free, the ability to beef up your super fund at the same time through salary sacrifice and, potentially, to increase your total income as you wind down your workload.

For detailed columns on TTR, please see here (8/12/11) and here (28/1/11).

But the fact is that even after turning on that pension with all of your accumulation funds, the accumulation portion of your fund will often start from scratch and grow again, with employer 9% superannuation guarantee (SG) contributions, salary sacrifice, and/or while you continue to make concessional contributions when you are self-employed.

It’s also a fact that it’s usually later in life that the benefits of putting large amounts of non-concessional contributions (NCCs) into your super fund, potentially as you sell down assets in your personal name, become apparent.

At some stage, you will need to adjust your pension income to take into account the funds in accumulation. One way of achieving that is to roll back the first pension to accumulation, then start a new pension with the combined funds.

But that can be dangerous. It can lead to particularly bad tax outcomes on your death for your beneficiaries.

Here’s one scenario. Years after starting a pension for one member (or two), the trustees are considering what to do with the build-up of funds in the accumulation fund. Should they start a second ? Or should they have just one?

Scenario

A member turned on their pension five years ago, aged 57, with a balance of $500,000. Through defensive investing and minimum withdrawals, the fund is still worth $500,000.

Initially, it was a transition to retirement pension. It was made up of SG and salary sacrifice payments, with 50% being NCCs. The fund is therefore 50% tax free (because of the NCCs) while the rest attracts a 15% tax rebate (from an income tax perspective).

Over the next five years, the member sold a few investment properties and contributed a significant amount to their accumulation funds via non-concessional contributions (NCCs). At age 62, they had another $500,000 in their super fund. This time, the balance is $500,000 in NCCs.

(All figures could be potentially doubled if the member’s partner was in a similar position.)

The member, now 62, has two adult children.

One pension?

The “one pension” option is to roll back the current pension to accumulation, pick up the other $500,000, and then start a new pension with $1 million.

The unintended consequences of this are serious. By rolling back the existing pension to collect the funds in accumulation, and then to start a pension would cause the following to occur.

The $500,000 (50% taxable as CCs) would then get mixed with the remainder $500,000 (all NCCs). The result would be 25% taxable and 75% tax free for the entire fund.

If the member was to die after turning on the new pension (25% taxable, 75% tax-free), then it would continue to be paid tax-free to a dependant, such as the member’s spouse, or young children. No great damage done.

However, problems would be caused if the member had both dependants and non-dependants they wished to leave their super to. For example, both the spouse and adult children are being considered for some super inheritance.

If there were no dependants to pay the super to, then it would be partially taxable to the recipients, even if passed through the will.

By rolling back the first pension into the accumulation fund, you would “poison the pool”. At the point that it was rolled back, the whole fund would then become 25% taxable, with no way of splitting the two parts again.

Or two pensions?

As you don’t know when you or your partner are likely to die, here are some of the benefits of starting a second pension.

In this particular case – given there are adult children – it would make sense to start a second pension if you intended them to benefit from your super (or more broadly, your estate).

It actually allows you to plan for several eventualities. Firstly, that you die before your partner. Secondly, that you might like to pay out something of your super fund not just to your spouse, but to your adult children, tax effectively at the time of your death.

Here’s one way of setting it up to minimise the likelihood of bad tax consequences.

The first pension, set up five years ago, is an auto-reversionary pension (for the ATO’s current thoughts on these, see my column from 27/7/11) so that it continues tax-free to the spouse and young children, in the event of the bus collecting you.

Now, the second pension.

This is going to be started with the other $500,000. This is 100% made up of NCCs. It can therefore be passed to non-dependants (or anyone) tax-free.

The real benefits of this strategy includes:

• If you      pre-decease your spouse, you will be able to leave a completely tax-free      pension to your spouse and young children, because they are dependants.
• You will be able      to leave sums to your adult children on which minimal tax, potentially      none, is paid (depending on the level of tax-free contributions that make      up the pension).

Usually, the best way of doing this would be to use a binding nomination for Pension #2 so that it went to the adult children and an auto-reversionary pension for Pension #1 to go to the spouse and younger children.

Extension of minimum drawdown

Self-fund retirees won a further concession from the Federal Government in yesterday’s MYEFO update, with the extension of super pension drawdown relief.

The government announced that continued high volatility on financial markets warranted the relief, which will see the minimum drawdown figures reduced by 25% again for next financial year.

Drawdown relief started in FY2008-09, when the government announced that pension minimums could be halved to reduce because of slumping financial markets during the GFC. This 50% reduction was extended into FY10 and FY11.

For the current financial year (FY2011-12), the pension drawdown relief became 25%. The announcement from the government yesterday was that this 25% reduction will continue for 2012-13 financial year.

See the table below for the minimum drawdowns for past years, this year and next financial year.

Table 1: Minimum drawdowns

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The information contained in this column should be treated as general advice only. It has not taken anyone’s specific circumstances into account. If you are considering a strategy such as those mentioned here, you are advised to consult your financial adviser.

Bruce Brammall is director of Castellan Financial Consulting and the author of Debt Man Walking.