Back in 2021, some important changes were made to the rules governing how SMSFs paying retirement phase pensions work out the amount of their investment income that is exempt from tax (known as their “exempt current pension income” or “ECPI”).

Those changes gave certain funds an important decision to make about how to work out their ECPI. 

But first – a quick re-cap.

It’s generally well known that there are two methods for calculating ECPI:

• The segregated method (where the ECPI is just all the income on the segregated assets), and
• The actuarial certificate method (where an actuary certifies a % of the income that’s ECPI)

Since 1 July 2017, there have been some funds that are not allowed to use the segregated method. They are funds where, at the previous 30 June (so 30 June 2023 for 2023/24 returns), at least one member had:

• A total superannuation balance of more than $1.6m, and
• A retirement phase pension in place (in any fund).

(Since 1 July 2021, there’s actually been an exception to this rule. Funds that only had retirement phase pension accounts at all times during the year can still use the segregated method and just claim all of their investment income as ECPI without needing an actuarial certificate).

The flipside, of course, is that all other funds can use the segregated method.

For a few years, any fund that could use the segregated method was required to whenever all of the fund was entirely supporting retirement phase pensions. That's one of the other things that changed from 1 July 2021.

A fund might be segregated for part of the year or it might be for all of it. Some funds experienced lots of different phases in the same year – for example, a fund with two members might:

• start the year entirely in accumulation phase (1 July – 30 September),
• commence a retirement phase pension for just one member (1 October), and then
• commence a retirement phase pension for the second member (1 January) – so at this point the fund is exclusively supporting retirement phase pensions, and then
• receive some new contributions that are left in accumulation phase (1 April) – so the fund is back to being a mix of pension and accumulation accounts

Under the rules that apply by default, the trustee of this fund would have no choice but to use the actuarial certificate method to claim ECPI for 1 July – 31 December and 1 April – 30 June and the segregated method from 1 January – 31 March. For some funds it can be even more complicated (ie lots more distinct periods where fund was segregated or not segregated).

However, since 2021/22, trustees of funds like this have had a choice:

• take the default approach (use both methods at different times of the year as outlined above), or
• use the actuarial certificate method for the whole year.

A different choice can be made each year, it’s not something the fund has to decide once and then stick with the decision forever.

It’s also fine to make the choice that gives the best possible ECPI result. The trustee doesn’t have to have a non-tax reason for whatever decision they make. And the trustee doesn’t need to guess up front at the start of the year which method they want. They simply need to decide when they lodge the fund’s tax return. If they don’t make a choice, the “default” is that the segregated method will be used whenever the assets are entirely supporting retirement phase pensions.

Note that trustees only get one choice in a particular year. Think about a fund that has two different periods where it is “100% retirement phase pension accounts”. The trustee couldn’t choose to use the segregated method for just one of them but the actuarial certificate method for the rest of the year.

So there is definitely a lot of flexibility. But choices can also be complicated sometimes.

How will funds make the choice?

Let’s put some numbers around the SMSF above to illustrate. Their balances during the year are as follows:

In other words, the various phases of the fund during the year are as shown in Figure 1.

If this fund uses the default method (which would see the period from 1 January – 31 March treated as being segregated), the actuarial percentage for the rest of the year would be approximately 49%. It would be applied to income earned between 1 July and 31 December and then from 1 April onwards. All income in the period 1 January – 31 March would be ECPI.

If, on the other hand, the trustee makes a choice to use the actuarial certificate method for the full year, the actuarial percentage would be 62%. It would be applied to all income throughout the year.

So what choice would this trustee make?

Income spread roughly evenly throughout the year

Probable decision: whatever is easiest

In this case the choice of method makes no difference. It would make sense to choose whichever method is easiest for the trustee / accountant.

Large capital gain realised in February (most of the fund’s income)

Probable decision: default to segregated method

Capital gains that are realised on segregated assets are completely disregarded. They don’t use up capital losses carried forward from previous years, nor are they offset against capital losses realised in the current year. All other things being equal, if a very large part of the fund’s investment income is a capital gain realised while the fund’s assets are entirely supporting retirement phase pensions, it’s likely that the better method for ECPI will be the default ie: the segregated method for 1 January – 31 March and the actuarial certificate method (49%) for the income earned in the rest of the year. This would even include income received in 1 July – 30 September when the Fund was entirely in accumulation phase.

Large capital gain in August

Probable decision: make the choice to use the actuarial certificate method all year

At this point the fund is entirely in accumulation phase. However, income in this period will be subject to whatever actuarial percentage is calculated for the fund.

Hence it will make sense to choose whichever method gives the higher actuarial percentage (62%) – this percentage will be applied to all income at all times in the year.

In a fund like this, the actuarial percentage will always be higher if the “full year” approach is taken because the calculation can then be influenced by the very high pension balances during the period when the fund is entirely supporting retirement phase pensions.

Only income is a trust distribution in June

Probable decision: make the choice to use the actuarial certificate method all year

In this case, the income is received at a time when the fund is not entirely supporting retirement phase pensions. Hence it will be subject to an actuarial percentage no matter what method is chosen. It therefore makes sense to choose whatever method will give the highest percentage.

Only income is interest on a term deposit – amount is equally split between 1 August and 1 February.

Probable decision: default to segregated method

In this particular example, defaulting to the segregated method at least means that one of the interest payments is entirely tax exempt and the lower actuarial percentage (49%) will be applied to the other interest payment. It’s possible that a different set of account balances could produce a different outcome.

A hot tip: if unsure, try both

If the fund’s accountant uses Class or BGL 360, it is straightforward to simply run the numbers twice – once defaulting to the segregated method and once using the actuarial certificate method all year. Most actuaries can provide an estimate of the actuarial percentage without the need to formally request a certificate. The estimate can then be entered into the software and used to calculate ECPI.

Even if the certificate actually needs to be obtained to receive the percentage, few actuaries charge for re-issuing a certificate (Heffron certainly doesn’t). That means the accountant can experiment before landing on which method works best. Note that it will be important to ensure that the right certificate is used with the right settings in the software. In the examples above, for example, if the software reflects the fact that the default (segregated) method will be used, it will be important to use the actuarial percentage of 49% and ensure this is the “final” version issued by the actuary. The fact that the trustee might also hold an actuarial certificate based on a different configuration (the actuarial percentage method for the full year) doesn’t mean they can choose when to use it. ECPI will only be calculated correctly in that situation if the fund is also flagged as unsegregated all year.

We have recently updated our Super Companion Guide, Under the Microscope and Strategies sections for these changes. It’s a resource you really can’t do without.