What happens when a pension fails?

All superannuation pensions have rules about how they operate. One of the very important ones is how much is paid out to the recipient each year in the form of pension payments. Not paying the right amount can have disastrous consequences.

For the most common pensions – account-based pensions – the rule to watch for pension payments is paying at least a minimum amount each financial year.

The minimum amount changes every year because it’s based on the member’s account balance at the start of the year and their age at the time. For example, the minimum pension payment required for 2023/24 is based on the pension balance at 1 July 2023 and the member’s age on that date. A member who was (say) 71 on 1 July 2023 with $1m in their pension account at the time is required to take pension payments of at least $50,000 during 2023/24 (5% of their pension balance). The percentage goes up with age – for example, it’s 6% for people aged 75-79.

So what happens if our 71 year old discovers now (December 2023) that his SMSF didn’t actually pay the right amount in 2022/23?

Normally that means the pension has failed and it’s deemed to have stopped back on 1 July 2022 which has a number of impacts.

Perhaps most importantly, funds providing “retirement phase” pensions (ie pensions for people who have retired or met another condition that gives them full access to their super) normally get a tax exemption on some or all of their investment income such as rent, dividends, interest and capital gains.

That’s not available for failed pensions.

Let’s say this SMSF was expecting to pay no tax on 70% of its investment income because the pension account represented 70% of the fund. Failing to meet the minimum payment rules would mean the fund is back to paying income tax on all its investment income. That could be particularly disastrous if the fund had a lot of taxable income that year – for example, it sold an asset at a significant profit.

A second consequence relates to taxes potentially paid by someone who inherits this account in the future. All super is technically divided into two parts – a “tax free component” and a “taxable component”. These tax components are largely academic for the member themselves as long as they’re over 60. But they are critical if the pension account is inherited by someone who is not classified as a “dependant” of the pensioner for tax purposes. The most common example of someone who might inherit a super balance but is not a dependant is a financially independent adult child who inherits their parent’s super. These beneficiaries pay tax on the “taxable component”. So under the right circumstances, it’s a very important number. Failing the pension payment rules triggers particular changes to the calculation of the tax free component. In most cases, the outcome is detrimental if the pension account has increased in value during the year.

And last but not least, it’s a breach of the rules that will have to be noted by the fund’s auditor. It’s unlikely a breach like this would create any further consequences but it’s definitely something a trustee would want to avoid doing as a matter of routine. Regular breaches of the rules give the appearance that the trustee isn’t taking their responsibilities seriously.

Is there anything that can be done? (Particularly given the fact that losing the tax exemption on the fund’s investment income can be very costly.)

Fortunately, there are some circumstances under which the ATO will use its discretion to overlook a pension shortfall. The failure to meet the rules has to be due to an honest mistake by the trustee or something beyond their control. There are also some conditions:

• The shortfall has to be “small” (which means it has to be no more than 1/12^th of the proper minimum amount)
• The trustee must have met all the other rules for the pension
• A “catch up” payment must be made to cover the shortfall as soon as practicable after discovering it. This will be treated as if it happened in the previous year.

The trustee can use this discretion automatically (without formally going to the ATO to ask for it) once, and only once. That means if the fund has any pension that’s failed in the past, the trustee will have to go to the ATO the next time it happens. Equally, if a fund is paying multiple pensions and several of them fail at the same time, the trustee can only use this discretion automatically for one pension. They’ll have to seek the ATO’s permission to use it more broadly.

And it’s important to note that to meet the minimum pension rules, the required amount must be actually paid (in cash) before the end of the financial year. Trying to make an online transfer on 30 June that doesn’t actually arrive in the member’s bank account until 2 July won’t cut it. It’s always best to make sure the payments are all made comfortably before 30 June.

Failing to meet the minimum pension requirements can have serious consequences. While it’s common to assume that the special discretion to overlook a shortfall will solve every problem, it definitely won’t as its application is quite narrow. SMSF members and trustees are far better to make sure the correct amount is paid in the first place.

To get up to date, relevant information that is targeted for SMSF trustees, sign up for our free Trustee Webinars.  Held quarterly, these are presented by our Managing Director, Meg Heffron.