Beware – How negative earnings in super can have far-reaching implications [CPD Quiz]

02 November 2020

William Truong

William joined the TechConnect team in February 2013 and has more than 12 years of experience in the financial services industry. He is Technical Services Manager at IOOF.

The impact of the COVID-19 pandemic on investment markets means many Australians now face the prospect of having a smaller super balance than they had at the beginning of the year. The impact of negative earnings has far-reaching implications, particularly on the values of taxable and preservation components in super.

In this article, we use several case studies to explain the different ways in which negative earnings in super could affect your clients. We also include information on how the various components of super are taxed differently, how rollovers to pension phase are treated, and the implications for clients who have multiple super accounts.

How do we calculate the taxable components in super?

The calculation of the taxable components in super funds is based on the proportional rule under section 307-125 of the Income Tax Assessment Act 1997.

For income streams, such as account-based pensions, the tax-free and taxable components and their respective proportions are fixed when the pension starts. The same fixed proportions apply for all income and lump sum payments, including super death benefits. Any positive or negative earnings within that pension is attributed with the same tax proportions. The tax proportions will affect the liability to taxation, where applicable.

Taxable and tax-free components in accumulation phase

For accumulation accounts, the tax-free and taxable components are only calculated when a super benefit is paid as a lump sum, or on a rollover, for example, a commutation event. This means taxable components are only notional until a commutation is made.

As a reminder, the three steps below explain how to calculate the tax-free and taxable components:

  • Step 1: Identify the tax-free and taxable components of the total super fund account balance immediately prior to the benefit being paid.
    • The tax-free component = the crystallised segment[1] at 30 June 2007 plus the contributions segment[2] (tax-free contributions and any amounts rolled in after this date) less tax-free components paid from the fund.
    • Taxable component = total super fund account balance less tax-free component.
  • Step 2: Determine the proportion of tax-free and taxable components of the total superannuation interest.
  • Step 3: The proportion calculated from Step 2 must then be applied to the benefit payment to determine its tax components.

Case study 1: Accumulation – calculating tax components on commutation

Ben has a super fund which has a balance of $400,000 with the following tax components:

Super balance as at Year 1 Tax components
$400,000 $350,000 tax-free
$50,000 taxable

Ben wishes to take a lump sum of $10,000 (assuming he meets a condition of release):

  • Step 1:
    • Tax-free component = $350,000
    • Taxable component = $50,000 ($400,000 – $350,000)
  • Step 2: the proportion of tax-free ($350,000/$400,000 = 87.5%) and taxable components (12.5%) of the total superannuation interest.
  • Step 3: 87.5% x $10,000 = $8,750 tax-free with the balance of $1,250 being taxable.

How do positive earnings affect the taxable and non-taxable components?

If there are positive earnings, the super fund will accrue these towards the taxable component only.

Case study 2: Accumulation – positive earnings

Continuing with Ben’s previous example, let’s assume he hasn’t taken the $10,000 lump sum and the fund balance has increased to $430,000. We now have the following tax components:

Super balance at Year 2 Tax components
$430,000 $350,000 tax-free
$80,000 taxable ($430,000 – $350,000) 


The positive earnings have been attributed to the taxable components. These values are only calculated upon a commutation being made. The proportion of the tax-free component to the total account balance has now been reduced from 87.5 per cent to 81.4 per cent.

How do negative earnings affect the taxable and non-taxable components?

In contrast, negative earnings in super reduces the tax components in the following order:

  • First reduces the taxable components.
  • Then reduces the tax-free components.

Case study 3: Accumulation – large negative earnings

Continuing with Ben’s example, let’s assume he hasn’t taken the $10,000 lump sum and his super balance is reduced by a large amount in year two:

Super balance at Year 2 Tax components
$300,000 $300,000 tax-free (potential of $350,000)
Nil taxable ($300,000 – $300,000) 


The super balance has fallen by $100,000. As this is greater than the original taxable component of $50,000, it reduces the taxable component to nil. Next, it also reduces the tax-free component by $50,000 to $300,000. The proportion of the tax-free component relative to the total account balance has increased.

These amounts are notional values, which means they haven’t been calculated yet. The tax-free component can still potentially be restored back up to $350,000 when there are positive earnings, if we assume no commutations are made, the fund remains open and there are concessional contributions made.

How else can the tax-free and taxable components change?

There are several ways the tax-free and taxable components can change. To explain this, let’s look at the following situations for Ben:

  1. Closes his account by rollover to another super fund.
  2. Keeps the same account open.
  3. Transfers his super benefits entirely to start a pension.
  4. Rollover to another super fund

Case study 4: Accumulation – rollover to another super fund

If Ben is unhappy with his fund’s performance and decides to rollover to another super fund, the following applies.

Super balance at Year 2 Tax component
$300,000 $300,000 tax-free (now capped at $300,000)
Nil taxable ($300,000 – $300,000)

If Ben closes his account in year two and rolls over to another super fund, fund A will calculate the tax components before rolling over to fund B.

There is no taxable amount at the time of calculation because the negative earnings first reduces the taxable component to zero and the tax-free component is set at $300,000.

The new fund will record a tax-free component of $300,000, which is the capped amount. The tax-free component can, however, increase if Ben makes additional tax-free contributions or further rollovers with tax-free components. 

  1. Keeping the same super account open

Case study 5: Accumulation – keeping the same super account open

If Ben retains his super fund and it experiences positive earnings in the following year, then, assuming no commutations have been made, the following applies:

Super balance at Year 3 Tax component
$330,000 $330,000 tax-free (potential of $350,000 is retained)
Nil taxable ($330,000 – $330,000)

 

If the fund experiences positive earnings again, growing from $300,000 to $330,000, the notional value of the tax-free components is now $330,000 and the potential tax-free component of $350,000 is retained, as earnings can effectively restore the tax-free component back to this potential level.

  1. Rollover to start a pension

Case study 6: Accumulation – commencing a pension which meets a condition of release

If Ben can meet a condition of release, he may commence an income stream, such as an account-based pension, and lock-in a higher proportion of tax-free components.

Pension balance at Year 2 Tax component
$300,000 full account-based pension (100% tax-free pension) $300,000 tax-free (crystallised at $300,000)
Nil taxable ($300,000 – $300,000)

If Ben uses $300,000 to start an income stream, the tax-free proportion is calculated at 100 per cent, rather than 87.5 per cent if he commenced it earlier in year one.

All payments, including death benefit, from the pension are 100 per cent tax-free and any future positive earnings will be added to the tax-free components only.

If Ben later decides to roll back into accumulation and start a new pension, it may not be 100 per cent tax-free due to earnings while in accumulation phase.

In anticipation of a rising investment market, clients who can meet a condition of release may be able to commence an income stream, such as an account-based pension, and lock in a higher proportion of tax-free components.

How do negative earnings using rollovers from multiple super funds affect the tax-free and taxable components?

In the case studies below, we explain how the rules affect rollovers with multiple super funds when clients want to consolidate their funds.

Case study 7: Jan has multiple super funds

Consider the following super balances in year one:

Super balance at Year 1 – ABC super fund Super balance at Year 1 – XYZ super fund
$350,000 tax-free Nil tax-free
$50,000 taxable $300,000 taxable
$400,000 total super balance $300,000 total super balance 


Consider the following super balances in year two with negative earnings of 20 per cent:

Super balance at Year 2 – ABC super fund Super balance at Year 2 – XYZ super fund
$320,000 tax-free (notional tax-free of $350,000) Nil tax-free
Nil taxable $240,000 taxable
$320,000 total super balance $240,000 total super balance

 Comparison of Jan’s consolidation options:

Consolidate into ABC super fund Consolidate into XYZ super fund
$350,000 tax-free (value of potential tax-free amount) $320,000 tax-free (set at the time of calculation)
$210,000 taxable ($560,000- $350,000) $240,000 taxable ($560,000 – $320,000)
$560,000 total super balance $560,000 total super balance

If Jan rolled her whole interest from the ABC fund to the XYZ fund, the XYZ fund would inherit the proportions of her original super interest that existed in the ABC fund immediately prior to the rollover. That is, the rollover amount of $320,000 would be 100 per cent tax-free. The trustee of the XYZ fund would then use this amount and proportions of the rollover benefit to calculate the components of Jan’s super interest in the fund.

Therefore, by rolling the ABC fund to the XYZ fund, Jan would effectively reduce her tax-free component by $30,000, whereas originally it was $350,000.

Alternatively, if Jan consolidates her super into the ABC fund, she would retain the higher $350,000 tax-free component.

How do negative earnings impact preservation components?

Investment market declines can affect any ‘Unrestricted non-preserved’ super benefits your clients may have in their super fund. Unrestricted non-preserved benefits allow clients to have access to these amounts at any time because they have previously met a condition of release in respect of these amounts.

Positive earnings in super funds only increase the member’s ‘preserved’ benefit.

In contrast, under section 6.16A of the Superannuation Industry (Supervision) Regulations 1994 (SISR), negative earnings in super funds impact the preservation components in the following order:

  • First reduce preserved benefits.
  • Then reduce restricted non-preserved benefits (RNP).
  • Then reduce unrestricted non-preserved benefits (URNP).

Super fund earnings are generally credited/debited to preservation components at 30 June each year. However, this date may differ between super funds, so it’s best to confirm the date with the relevant super fund.

Once negative earnings are debited to RNP and URNP components, these components become fixed and are permanently reduced, unlike the tax components discussed above.

Case study 8: Jenny – negative earnings impacting super preservation components

Jenny’s super balance as at year one (reporting date)

Super balance Preservation components
 $300,000 $260,000 unrestricted non-preserved
$40,000 preserved components

Jenny’s super balance as at year two (reporting date) – drops by 20 per cent (equating to $60,000)

Super balance Preservation components
 $240,000 $240,000 unrestricted non-preserved
Nil preserved components

 The first step is to reduce the preserved components to zero. The negative earnings are larger than the preserved components. The excess of $20,000 reduces the unrestricted non-preserved components. At the reporting date (in this example we have assumed this to be 30 June 2021), Jenny’s super fund calculates her preservation components and the unrestricted non-preserved component reduces by $20,000 permanently.

Later, when investment markets recover and Jenny’s super goes back up to $300,000 and her unrestricted non-preserved benefit remains at $240,000, it cannot increase to its original value of $260,000, presuming Jenny does not meet a new condition of release.

Alternatively, if Jenny contributes $20,000 or accepts a rollover from another super fund before 30 June 2021, her preservation components will be as shown below. Jenny avoids any reduction to her unrestricted non-preserved benefits:

Super Balance Preservation components
$260,000 ($240,000 + $20,000) $260,000 unrestricted non-preserved
Nil preserved components

When topping up super, the super fund must first increase the unrestricted non-preserved component, as it’s the preserved components that is first impacted by the negative earnings. In this case, the reduction from the previous reporting date from $300,000 to $260,000 is only $40,000, which reduces the preserved component to nil. There is no excess reduction to reduce the unrestricted non-preserved components.

The aim is to ensure your client’s total benefit is equal to or greater than the original value of their unrestricted non-preserved benefits in the fund.

Conclusion

Large negative losses not only impact a client’s retirement savings, they can also impact a client’s taxable components and preservation components. Depending on a client’s situation, there are several taxation implications which should be considered to ensure the best outcome for clients and to preserve their tax-free component and unrestricted super benefits.

William Truong, Technical Services Manager, IOOF TechConnect.

Footnotes

  1. The crystallised segment of a super interest is a fixed dollar figure based on the 30 June 2007 value of the following components: concessional component + post-June 1994 invalidity component + undeducted contributions + CGT exempt component + pre-July 1983 component.
  2. The contributions segment of a super interest consists of contributions made after 30 June 2007 to the extent that they have not been included in the assessable income of the super fund, for example, non-concessional contributions.

***

QUESTIONS

To answer the following questions, go to the Learn tab at moneyandlife.com.au/professionals

1. When negative earnings impact super tax components, which of the following statements is incorrect?

a. It first reduces the tax-free component.

b. It first reduces the taxable components.

c. Commencing a pension will crystallise the tax components.

d. Partially rolling over to another super fund will crystallise the tax components.

 

2. Regarding preservation components, which of the following statements is true?

a. At reporting date, the unrestricted non preserved component may get reduced but it can increase back up with future positive earnings.

b. Preservation components are crystallised at the super fund’s reporting date.

c. Large negative earnings reduce unrestricted non preserved components first.

d. We do not need to know the fund’s reporting date.

 

3. When consolidating super funds where there are negative earnings, which of the following is correct?

a. It doesn’t matter which fund is being consolidated into.

b. Consider implications on tax components.

c. Consider implications on preservation components.

d. Consider implications on tax and preservation components.

 

4. To preserve the tax-free components when there are negative earnings in super, which of the following statements is incorrect?

a. You do not have to do anything, as there is no crystallisation event (i.e. until there is a commutation).

b. There is an opportunity to commence a higher tax-free percentage pension or withdrawal.

c. If consolidating multiple super funds, consider which fund to retain.

d. We can selectively drawdown from the taxable components only to preserve the tax-free components.

 

5. Ben has a super fund which has a balance of $400,000, of which $50,000 consists of the tax-free component and $350,000 is the taxable component. After two years of negative returns, Ben’s super drops in value to $100,000. If Ben were to then commence an account-based pension (ABP) using his entire balance ($100,000), what proportion of the ABP will be tax-free?

a. 100 per cent.

b. 50 per cent.

c. 5 per cent.

d. Nil.

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