How to convert self-managed super into tax-free pensions

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There are good reasons why it usually makes sense for members of self-managed superannuation funds to convert their super into tax-free, account-based pensions when they retire.

Among them is the fact that deciding in favour of an account-based pension still leaves open the option of taking a large tax-free payout at any time.

This payout could be classified, at the member's discretion, either as a pension payment or a lump sum payout, usually referred to a commutation.

Under the rules there is no limit on how much of the pension can be commuted.

Graeme Colley, the technical director at the SMSF Professionals' Association of Australia, says that, while this option also is available to members of public super funds, members of an SMSF whose trust deed permits lump-sum payments are often in a position to make very targeted use of this provision.

In particular, under the superannuation rules it is not possible to finance pension payments by making "in specie" transfers of investments to a member of the SMSF.

Given that SMSFs often hold a very diverse range of assets - from shares and real estate to art and other collectables - this ban could raise problems for a retired member who wanted to make personal use of some of the fund's assets.

Fortunately, this particular ban does not apply to lump-sum payouts. This means that a member could ask to have an in specie transfer made to them in the form of a lump sum.

As usual, however, there is more than one issue to take into account when making a superannuation decision.

For those retirees who are getting a part age pension from the government, or think they may qualify in the future, the most important consideration is the way Centrelink views account-based pensions and lump-sum payments.

As Colley explains, if a large payout was classified as a pension payment, it would be included as part of the age pension income test for the year in which the payment was made. The result would be a lower - or possibly no - age pension for that particular year.

The actual amount of the lump sum usually won't be included as part of the income test.

Rather, it will affect a person's pension because of its impact on the so-called deductible amount.

Under existing rules, the amount Centrelink counts as income is calculated by taking the gross annual pension payment minus the deductible amount.

This is the amount you used to set up the pension, divided by your life expectancy at the time the pension commenced.

The deductible amount is recalculated when you make a partial commutation, the resultant smaller deductible amount resulting in a larger income for income test purposes and so a smaller pension.

Other things being equal, these rules mean someone who is not yet receiving any age pension is likely to be better off, for Centrelink purposes, taking any large withdrawal as a pension payment.

In contrast, those receiving a part age pension will need to compare the immediate impact of taking a larger pension against the long-term impact of having a smaller deductible amount.

Super tip

An SMSF member thinking of living or working outside Australia should get advice about how to ensure their period overseas doesn't make the fund non-compliant.

If it did, the fund could end up having its earnings taxed at the top marginal tax rate.

The risk of non-compliance arises because SMSFs must be managed and controlled within Australia, which means its members, as the trustees, should live here.

In general, however, the tax office accepts that members may need, from time to time, to reside outside Australia temporarily.

In the past this has been defined as a maximum of two years but make sure you get expert advice before you make the move.

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Peter Freeman is a former managing editor of The Australian Financial Review. He runs his own self-managed super fund.