Certain defined benefit income streams are subject to commutation restrictions and from 1 July 2017, they are to be referred to as ‘capped defined benefit income streams’.

This article is for educational purposes only and is no longer available for CPD hours.

The new $1.6 million transfer balance cap is often described in terms of a cap applying to account based pensions, however, it relates to all retirement pensions, including non-commutable fixed term and lifetime defined benefit income streams. These income streams include those paid from SMSFs, corporate super schemes and government schemes.

To ensure that clients with these income streams experience similar tax concessions to traditional pensions, special valuation rules apply when calculating whether the client has an excess transfer balance, as measured against the $1.6 million general transfer balance cap.

Special rules also ensure that a client cannot have an excess transfer balance if the excess is attributable to these defined benefit income streams. Instead, the rules impose additional PAYG tax on income above a certain limit to ensure different super schemes are subject to broadly commensurate tax concessions.

Types of capped defined benefit income streams

There are two categories of defined benefit income streams:

1. Lifetime income stream (commenced at any time)
   Lifetime pensions are often provided to Commonwealth, State and Territory public office holders, and military and civilian employees. Most of these schemes are closed to new members. However, existing members are entitled to receive pensions in the future. The extension of the rules to these pensions reflects the fact that while the client’s pension may not have started before the application of these amendments, their pension is part of a long-standing arrangement to which there is an existing legal entitlement.
2. Term income stream (commenced before 1 July 2017)
   Life expectancy and market-linked products are collectively referred to as term pensions and term annuities.

Special rules

There are special rules to determine the value of a defined benefit income stream applying to a client’s transfer balance account. The rules in Table 1 apply to these types of defined benefit income streams.

Table 1

The special value credit applies to a client’s transfer balance account and is also used to determine a client’s eligibility in relation to other areas of the law, for example, making catch-up concessional contributions.

Lifetime pensions and annuities that are capped defined benefit income streams are valued by multiplying the annual entitlement by a factor of 16. This means that a defined benefit pension that pays $100,000 per year would fully exhaust the $1.6 million transfer balance cap in the 2017/18 financial year. The single factor of 16 is used regardless of the client’s age, gender, earnings on their assets, or the rates that can be drawn down.

Meanwhile, term pensions and term annuities are valued according to the superannuation income stream’s annual entitlement multiplied by the number of years, rounded up to the nearest whole number, remaining on the term of the product.

The annual entitlement is calculated by annualising the first payment the client is entitled to receive after the valuation is required.

The formula to calculate the annualised entitlement is: Annual entitlement = (first payment / days in period) x 365

The first payment is annualised based on the number of days in the period to which the payment refers.

Example 1: Valuation of a lifetime defined benefit pension

On 1 July 2017, Sarah receives a lifetime pension. Under the terms of the pension, Sarah is entitled to receive $2,000 every fortnight. Her annual entitlement is worked out as follows: $2,000 / 14 × 365 = $52,142.86.

Applying the multiplication factor of 16, Sarah’s pension has a special value of $834,285.71. A credit arises in Sarah’s transfer balance account for this amount. Subsequent increases to the income stream benefit relative to the first payment owing to indexation do not have an effect on the calculation of the annual entitlement.

Example 2: Valuation of a term defined benefit pension (purchased before 1 July 2017)

Steve purchases a market-linked pension in January 2017. The term of the pension is five years. At 30 June 2017, the pension has an annual entitlement of $100,000. The remaining term is rounded up to five years. The pension has a special value of $500,000.

Determining the excess

How do you determine the excess when there is a capped defined benefit income stream?

When a client has a capped defined benefit income stream, they will have a separate special balance, which is called the ‘capped defined benefit balance’. This capped defined benefit balance is a sub-account of the client’s ‘transfer balance account’ and reflects the net amount of capital a client has transferred to the retirement phase in respect of capped defined benefit income streams.

No upper cap applies to the capped defined benefit balance, which means clients cannot have an excess transfer balance to the extent the excess is attributable to these defined benefit income streams.

However, in calculating whether clients may have an excess for the purpose of the pension cap, the excess is calculated as the lesser of the amount that exceeds both:

• the personal transfer balance cap; and
• the capped defined benefit balance.

There is an excess when the client has exceeded both of these caps.

Example: Excess benefits

On 1 July 2017, Peggy starts to receive a lifetime pension with a special value of $2 million. The amount of $2 million is credited to Peggy’s transfer balance account and to her capped defined benefit balance.

Although Peggy’s transfer balance exceeds her $1.6 million transfer balance, Peggy does not have an excess transfer balance because the excess is entirely attributable to her capped defined benefit income stream.

Peggy is not required to reduce her retirement phase interests.

On 1 December 2017, Peggy purchases an account based income stream for $300,000, this is in addition to her capped defined benefit income stream. The amount of $300,000 is credited to Peggy’s transfer balance account, which now increases to $2.3 million.

In Peggy’s case, she exceeds both:

• her normal pension transfer balance account by $700,000 ($2.3 million less $1.6 million); and
• her separate capped defined benefit balance by $300,000 ($2.3 million less $2 million that relates to her capped defined benefit pension).

As the lesser of these amounts is $300,000, Peggy’s excess is $300,000 and not $700,000. Peggy will be forced to commute $300,000 from the account based income stream back to accumulation or as a lump sum out of the superannuation system. She will be subject to excess transfer balance tax until she commutes the excess amount.

If the new superannuation income stream is insufficient to fully remove the crystallised reduction amount of $300,000 plus notional earnings, any remaining excess will be written-off.

Application of special tax rules

In terms of the application of special tax rules to capped defined benefit income streams, the following applies.

From 1 July 2017, special tax treatment applies to pension payments from the capped defined benefit income streams if clients are aged 60 or over, or those clients who are receiving death benefits from a deceased individual age 60 or over.

These types of clients are entitled to concessional tax treatment up to their ‘defined benefit income cap’.

The defined benefit income cap is calculated as the general balance cap divided by 16, which is $100,000 per year in 2017/18.

Taxation of defined benefit income streams

Taxation of defined benefit income streams for clients age 60 or over is summarised in the Table 2.

Table 2

Under the current rules, it’s important to note that for those aged 60 or over, there is no limit to the amount of tax-free and taxable components of pension income that can receive concessional tax treatment.

Superannuation income streams may be from a taxed or untaxed source, or a combination of the two. Taxed source and tax-free component defined benefit income is considered first and is applied to the defined benefit income cap before any untaxed source income.

To the extent the client’s taxed sourced or tax-free defined benefit income exceeds their defined benefit income cap, 50 per cent of the amount is included in their assessable income.

Example: Taxation of taxed sourced defined benefits

During 2017/18, Franke, aged 62, receives defined benefit income of $150,000 from her funded defined benefit scheme. The defined benefit income cap for the 2017/18 financial year is $100,000 (the $1.6 million general transfer balance cap divided by 16). Franke’s defined benefit income exceeds the income cap by $50,000. Therefore, $25,000, which is 50 per cent of the $50,000 excess, is included in her assessable income and taxed at her marginal tax rate.

If there are any untaxed source income, it is considered next. Excess untaxed source defined benefit income is worked out by applying the client’s untaxed defined benefit income stream payments to any amount remaining in their defined benefit income cap (after having applied taxed source and tax-free component defined benefit income). Any amount that exceeds the cap is not entitled to the tax offset.

Example: Taxation of both taxed and untaxed sourced defined benefits

Richard, who is 61, has a hybrid defined benefit pension and receives $180,000 of defined benefit income in 2017/18.

His pension comprises of:

• $20,000 tax-free component;
• $75,000 taxed component; and
• $85,000 untaxed component.

We first look at the tax-free and taxable components which total $95,000. This amount is counted towards Richard’s $100,000 defined benefit income cap.

The first $5,000 of the untaxed component is also counted towards the cap, thereby exhausting it. The remaining $80,000 of untaxed component is not entitled to a tax offset.

Richard’s tax offset is limited to $500, which is 10 per cent of the $5,000 counted towards the cap.

The same outcome would occur if the elements were from separate superannuation income streams, regardless of when either income stream was established.

Defined benefit income stream cap – reduced cap

Defined benefit income that is subject to concessional tax treatment can count towards the defined benefit income cap.

Clients who are below age 60 and are receiving income from defined benefit income streams will continue to be taxed in the usual manner, which means they are taxed at marginal tax rates less a 15 per cent tax offset that applies to the taxed component. These clients are now categorised as clients who don’t receive concessional tax treatment, even though they do receive a tax offset.

The defined benefit income cap is reduced if a client receives defined benefit income that is not subject to concessional tax treatment, as shown in the next example.

Please note that if the client first becomes entitled to that pension part-way through a financial year, their defined benefit income cap is reduced proportionately.

Example: Reduced cap due to non‑concessional income stream

Ben, aged 58, receives $150,000 of defined benefit income in 2017/18. This consists of $80,000 of superannuation income stream member benefits and $70,000 of dependant death benefits.

Ben receives the death benefits because of an entitlement to the super interests of his late wife, Laura, who was 61 when she died. These super income streams are from a taxed source.

Ben is entitled to treat these death benefits as concessional income but not his member benefits, because he is under age 60.

The defined benefit income cap is reduced, as Ben receives defined benefit income that is not subject to concessional tax treatment.

In this case, Ben’s defined benefit income cap for the 2017/18 financial year is reduced to $20,000. Calculated as $100,000 less $80,000 owing to his non‑concessional income stream.

The first $20,000 of the taxed component from the concessional income stream, which is the death benefit income stream, is also counted towards the cap, exhausting it. There is no tax on this component.

Ben’s death benefit income exceeds the income cap by $50,000. Therefore, $25,000, which is 50 per cent of the $50,000 excess, is included in his assessable income and taxed at his marginal tax rate.

Please note that non-concessional defined benefit income, the $80,000, is used to reduce the cap, but it cannot contribute towards an individual’s excess amount.

Example: Reduced cap due to part year start of defined benefit income stream

Max receives income payments from a defined benefit fund. Max turned 60-years-old on 12 September 2017. Max becomes entitled to concessional tax treatment on this date. Max’s defined benefit income cap for the 2017/18 financial year is worked out as follows:

$1.6 million / 16 x (1 + 291)* / 365 = $80,000

* 291 represents the number of days remaining in the financial year.

Summary

Clients receiving large defined benefit income should be aware there may be a special value attributable to their defined benefit income stream against the $1.6 million general transfer balance cap and in addition, there may be PAYG tax to pay, which translates to a reduction in the amount of money they will receive.

SMSF members and trustees who are aged 60 or over need to register for PAYG. They also need to calculate, deduct and pay taxes owing to the ATO.

The ATO has further information on registration for PAYG at the following link:
www.ato.gov.au/Business/Registration/Work-out-which-registrations-you-need/Taxation-registrations/Pay-as-you-go-withholding/