When pensions aren't just for old people

Most people with superannuation pensions are retired or getting close. But there are some occasions when a pension can be paid to a much younger person and they bring some unique challenges and opportunities.

There are broadly two groups of people in this situation.

Some are seriously unwell or have been badly injured in an accident and meet specific definitions called “permanent incapacity” or suffering from a “terminal medical definition”. Those people can access their own superannuation much earlier than usual to help them deal with their situation.

The second group is likely larger – people who have experienced the death of a spouse. In that case, they are not accessing their own super, they are accessing the super of their deceased partner. Their own super is still locked up until retirement or when they are eligible to start a “transition to retirement pension”. But their spouse’s superannuation is treated quite differently. No matter how old the survivor is, they can take their deceased spouse’s super as a pension. So someone who loses their, say, 50-year-old husband at 45 can find themselves the recipient of a pension from their self-managed super fund (SMSF) way earlier than expected.

In some ways these pensions are exactly the same as pensions that a retiree might receive. But there are often quirks to watch out for.

Firstly, the pension uses up some or all of the survivor’s “transfer balance cap”. This is the maximum amount anyone can put into a retirement phase pension over their lifetime. It is currently $1.6 million but the general limit will increase to $1.7 million from 1 July 2021.

A quirk is that many couples have life insurance in their superannuation. Hence a super balance of, say, $1 million might become $2 million when a large insurance payout is added on. The insurance will count towards the transfer balance cap too if it is paid as a pension.

So in this case, the survivor might find themselves with a $1.6 million pension at 45. Anything over and above this $1.6 million will need to be paid out of super entirely – to the estate, the spouse or another beneficiary. This means that when the surviving spouse reaches her own retirement, she no longer has any of this cap left. All her super will need to just stay in the fund “accumulating” for the rest of her life or be paid out as a lump sum, but it won’t be possible to convert it to a pension.

‘There’s a catch’

In addition, the death benefit pension will mean the fund can claim a tax exemption on some or all of its investment income – just like every other retirement phase pension. All of a sudden, the 45-year-old widow has an SMSF that isn’t paying any tax on (say) half the fund’s capital gains, rent, interest, dividends. That creates all kinds of interesting and useful planning opportunities. It may be possible to sell assets with minimal tax implications or even invest in assets that pay a lot of income (because a lot of it won’t be taxed).

This could change many of the usual tax considerations for SMSF investing. The pension might also disrupt the widow’s own plans for making super contributions. Perhaps she was about to make some “non-concessional contributions” (contributions made from her own money for which she has not claimed a tax deduction).

Timing really matters

These contributions are currently limited to $100,000pa or up to three times this amount in one year. But there’s a catch with those limits – they are lower for people with high super balances.

For example, someone who had a super balance of $1.6 million or more at June, 30, 2020 has a limit of nil for non-concessional contributions in 2020/21. Initially, it’s only the surviving spouse’s own super that counts as part of her balance. But once she starts a pension from her late husband’s account, that balance will count too.

So timing really matters for someone whose spouse’s super will cause them to go over the limit. For example, starting a pension “now” will not only mean that the pension is capped at $1.6 million (the limit doesn’t increase until July 1, 2021).

The way in which the pension payments themselves are taxed is slightly quirky.

It will also mean that the pension will count in the widow’s total super balance at June 30, 2021 and her non-concessional contributions cap will be nil in 2021/22.

In contrast, if she dragged her heels and didn’t start the pension until July 1, 2021, she not only has a higher transfer balance cap ($1.7 million) but her husband’s super also has no impact on her contribution limits until 2022/23. This might be invaluable in allowing her to get one last year of making large super contributions.

And finally, the way in which the pension payments themselves are taxed is slightly quirky. If either the widow or her husband were over 60 when he died, the pension payments will be tax free no matter how old she is. In contrast, if they were both under 60 at the time he died, she has to wait until she turns 60 before the payments are tax free. (So you don’t want to be a 30-year-old widow of someone who died at 59.)

In the meantime, the taxable part of the pension is taxed at normal marginal rates but with a 15 per cent tax offset. The net result is that it’s not as bad as if the pension was just like any other income.

The death of a spouse is obviously a time for careful superannuation planning, but one of the very strange outcomes is that quite young SMSF members can end up with a pension.

This article first appeared in the AFR on March 19th 2021.