Allocating reserves in the new world

The 7 December 2024 changes to the treatment of reserve allocations certainly provide some excellent new opportunities to get rid of many SMSF reserves. But those who’ve already made allocations in (say) July 2024 should watch out for some traps.

In the past, the most common approach for allocating reserves in an SMSF was to use the so called “5% rule”. This rule allowed trustees to make reserve allocations that didn’t count towards any contribution cap providing two conditions were met:

• the allocation was “fair and reasonable” to all members of the fund (or a particular class of members), and
• the total allocation to an individual member over the full financial year was less than 5% of their super balance at the time the allocation was made.

Reserve allocations that didn’t comply with this rule were checked against a contribution cap – and before 7 December 2024, the relevant cap was the concessional contributions cap. From 7 December 2024 onwards, it’s the non-concessional contributions cap.

From 7 December 2024, other opportunities have opened up a lot. In particular, there are now many people who can allocate much larger amounts than 5% without worrying about contribution caps at all. And even those whose allocations will be checked against a contribution cap often have a larger cap to play with. At $120,000 - $360,000 (for most people) the non-concessional contributions cap is obviously far higher than the standard $30,000 concessional contributions cap.

We expect many people will dive into making large allocations “now” (in the months remaining in 2024/25) to take advantage of their new opportunities.

But remember that sometimes action taken “now” could impact how amounts allocated earlier in the year are treated.

For example, Donald’s SMSF (he is the only member) has a reserve that came about when his life expectancy pension ended a few years ago. It started with a 20 year term in 2003 and so it stopped at the end of that time (in 2023) even though there was money left in the pension account. Ever since, the trustee has been allocating “just less than 5%” to Donald’s accumulation account each July. At 30 June 2024 his super balance was $1m and his allocation on 1 July 2024 was $49,000 (ie, just under 5%). Unfortunately, even after allocating that amount earlier in the year, the fund still has $300,000 left in the reserve. Donald had initially resigned himself to this process taking a number of years!

Fortunately, the new rules mean this can change. Given how the reserve came about (from Donald’s own pension), the entire amount can now be allocated to him any time entirely cap free.

But before he dives in, Donald should check one thing.

If a further $300,000 is allocated to his account “now”, the total amount allocated during 2024/25 will be $349,000 ($49,000 in July 2024 and $300,000 “now”). This isn’t a problem for the latest allocation. But it does compromise the treatment of his initial $49,000.

While this was less than 5% of his balance at the time of the allocation, the 5% is measured looking at all reserve allocations for the full year. He’ll fail that test if a further $300,000 is allocated now.

Failing the test means the $49,000 will be checked against his concessional contributions cap ($30,000 in 2024/25) – and will exceed it. This might be fine. It simply means Donald will add the excess ($19,000) to his assessable income and pay tax on it at the usual marginal rates, less a 15% tax offset. Whether this is a problem depends on his other taxable income.

If it’s going to be a problem, Donald might prefer that the trustee waits until 1 July 2025 to allocate the remaining $300,000.

There are many more issues to consider in choosing how to allocate existing SMSF reserves – or new ones created by winding up legacy pensions. We have dedicated an entire webinar to explaining how these changes work and smart strategies for your clients when it comes to winding up reserves. If you haven’t already signed up for this webinar, register here to attend live or access the recording afterwards.