How to add some breathing space to your pension cap

In the world of superannuation, a “commutation” is the name usually used to describe prematurely ending a pension and there are a number of tips and traps to think about when that happens.

But it is also possible to partially commute a pension – with different consequences and benefits.

In fact, partial commutations are very common these days. That’s because any commutation from a retirement phase pension (that is, one that has counted towards the cap – $1.6 million to $1.7 million – on the amount a person can turn into a pension over their lifetime) gets special treatment when it comes to this cap.

Specifically, a partial commutation is treated like a small reversal of the amount of cap that has been used up.

For example, someone who started a pension with the full $1.7 million pension cap amount but then later took a partial commutation of $200,000 is regarded as having used up only $1.5 million ($1.7 million less $200,000) of their cap.

They can top back up to $1.7 million in the future by starting another pension with up to $200,000. This ability to create some “space” in the pension cap is extremely useful for people who know they are likely to use it in the future.

Downsizer Contributions

The types of trustees this would help include someone who might later sell their home and make special contributions allowed at that time (downsizer contributions) or someone who inherits their spouse’s super.

In both cases, having a bit of space available in the pension cap means it can be used to start, or continue, pensions from these new amounts in the future.

For that reason, it’s a common strategy for people with large pension balances to take the bare minimum each year as a normal pension payment but treat any other payments as “partial commutations”.

For people over 60, both are completely tax free – so there’s no downside but plenty of upside.

But what do we need to watch out for?

A partial commutation can be taken at any point during the year even if no normal pension payments are taken beforehand (that is, it’s not necessary to take the pension payments first or at least have them “up to date” before taking a partial commutation).

Five Top Tips

But the trustee has to make sure that there is enough left in the pension account after the partial commutation to still make the full year’s pension payments. That leads to my tips.

1. The full year’s payments still have to be paid even when the partial commutation is very large. There’s no process to reduce the payments required for the rest of the year even if the commutation represented the vast majority of the account.
   
   
2. The partial commutation itself doesn’t count towards the minimum pension calculations. It’s therefore possible to take a huge amount of money out of a pension and yet still fail the minimum payment requirements! Make sure that doesn’t happen by taking normal pension payments as well. A unique feature of partial commutations is that they can be paid by transferring assets out of the fund rather than paying cash (this is often called an “in specie transfer). In contrast, pension payments have to be in cash.
   
   
3. Partial commutations are therefore a great solution for SMSFs where the member wants to transfer a particular asset out of the fund.
   
   
4. Don’t forget to report the commutation to the ATO by preparing a Transfer Balance Account Report (TBAR). The pensioner’s transfer balance account is the running tally of all the amounts that have counted towards the $1.6 million to $1.7 million pension cap. Since one of the great benefits of a partial commutation is that it reduces this running tally, it’s important to get the reporting right.
   
   
5. Not all partial commutations result in money (or assets) being paid out to the pensioner. Sometimes people do partial commutations to transfer money from their pension account back to an account that’s just accumulating in the fund.
   
   There are lots of good reasons to do this, but that’s a topic for another day. Remember if a partial commutation is rolled back into accumulation phase, it will mingle with any money already sitting in the member’s accumulation account.
   
   All super (both in pension and accumulation accounts) is divided into two different components for tax purposes – a part that is taxed if it’s paid to (say) an adult child when the member dies, and a part that’s never taxed.
   
   There are good reasons to keep the two separate if possible and sometimes that’s done by carefully starting pensions at the right time. But if part or all of the pension is switched off (commuted) and mixed with the accumulation account, the tax components of the amounts involved will also be mixed. Like eggs, they can’t be unscrambled.

This article was first published in the Australian Financial Review 25th November 2021.