Australian superannuation - how it works

Introduction

This is an attempt to provide a simple guide to the Australian pension scheme with particular regard to self managed superannuation funds (SMSFs).

If you are thinking of starting your SMSF but know little about how pensions work in Australia, I hope this article will act as a starter for you.

The basic concept

The basic concept behind the Australian superannuation scheme is straightforward: you can put money and assets in a superannuation fund and if you are self-employed you can obtain personal tax relief in doing so. If you are employed, your employer is obliged to make superannuation fund payments for you (you do not pay personal tax on this money). And you may be able to put more money in the fund by sacrificing part of your salary (you do not pay personal tax on this money).

Generally you can't withdraw from the fund until you reach a certain age or retire. Whether you have to take a pension or whether you can withdraw all the money, and whether you have to pay any tax on the withdrawal depends on your age and whether you have retired. If you are still working and you are approaching 60 you can take a "transition to retirement pension". If you are retired and approaching 60, or if you are 65 and over, you can withdraw as much as you like. If you are not yet 60 when you take the money out, part will be taxable but significant tax concessions apply; after the age of 60 withdrawals are tax free. The basic aim is to provide you with a decent level of capital and income later on in life.

As for the internal tax treatment of the fund, before the fund starts to make any payments to you, it pays tax of 15% on its income. The fund also pays tax at 15% on contributions into the fund where the source of the contribution is untaxed money (except for high earners when it is 30%). After the fund starts making payments to you, provided you have retired or have reached 65, it will not pay tax on the income from the assets set aside to enable those payments to be made.

See below for more information about internal taxation of the fund.

The Self-managed Superannuation Fund

An SMSF is a superannuation fund which you yourself can manage directly. Some people are happy to manage all aspects of their SMSF, dealing with all paperwork, making all investment decisions, carrying out all transfers and transactions, preparing their own accounts and submitting their own fund's tax returns to the Australian Tax Office (ATO). If they do this, they are independent from all except the professional auditors required for the obligatory annual audit.

I am a barrister practising in Australia and I am one of those people who manage all aspects of my own SMSF. This is of professional interest to me. My trust deeds, corporate constitution and guidance packs are on sale on this site. My aim is to provide these documents (and if necessary to provide further advice) at a reasonable cost to those who wish to set up and run an SMSF.

Most people prefer to engage professionals to do some or part of the work. In Australia there is quite an industry in offering SMSF services - lawyers, financial and investment advisers and accountants.

The pension scheme in more detail

It is the age of the member of the superannuation fund which largely controls how the fund must operate with respect to that member, and the table below sets out what is permitted by way of contributions and receipts in the different age ranges.

The basic scheme is that normally you can't take any receipts from the fund until the "preservation age" which is between 56 and 60 (depending on your date of birth - see below). If you take receipts at that age part of it may be taxed in your hands although there are tax concessions. After you reach 60 all receipts are tax free. At age 65 or earlier retirement after preservation age, you can take part of the fund or the whole of it as a lump sum, or as an income stream or both.

Employee's withdrawal

One exception to the above is that on leaving an employment at any age, it is lawful to withdraw the contributions that your former employer made into your superannuation fund. In the case of employer's contributions made before 1 July 1999 these can be taken as a lump sum (they are restricted non-preserved benefits).
In the case of employer's contributions made after 1 July 1999, these can only be taken by pension or annuity and not by way of lump sum (unless the lump sum would be less than $200).
[This type of withdrawal is permitted by item 108 in Schedule 1 of the Supervision Industry (Supervision) Regulations 1994. However it appears to be discouraged by employer's superannuation schemes and very few permit this. It could be permitted by your SMSF if it received employer contributions].
The ability to make contributions into the fund diminishes as you get older and once you reach 65, to continue to make contributions you will need to continue working to some extent (you would need to satisfy the work test).

If you are self-employed, your personal contributions are 100% tax deductable from your income (they count towards your concessional contributions cap). From 1 July 2017 the 10% rule is abolished so you can make such contributions even if you are in employment as well.

If you are employed, your employer will be obliged to make superannuation contributions (currently 9.5%* of your notional earnings) into a superannuation fund, which can be your SMSF. You can also make a salary sacrifice arrangement with your employer to increase this proportion. You will not pay income tax on that part of your salary which is used to make these contributions. They are regarded as employer contributions and count toward your concessional contributions cap.

* This is planned to increase in staggered steps to 12% by 2022-23.

Any contribution which you make into the fund for which you have claimed a deduction from your income (a concessional contribution) is taxed on receipt into the fund, payable by the fund. The rate of tax to be paid on such a contribution is 15% or 30%* for contributions in respect of members earning more than a certain annual amount. That annual amount is $300,000 in the tax year to 30 June 2016, or $250,000 in subsequent tax years.

* This is called Div 293 tax.

If you are between the preservation age and 65 or between 65 and 75 and still working, the contributions and receipts rules overlap. This means it is possible to contribute to the fund at the same time as withdrawing from the fund. Whether any such contributions need to be made into a separate accumulation account will depend on new rules from 1 July 2017. From that date the fund's income from assets of the fund set aside to pay a transition to retirement pension is no longer free of tax. On the face of it, there will be little point in segregating those assets from new contributions into the fund (advice will be needed on this however). If you receive a pension from the fund at age 65 or above, then contributions would definitely need to be made to a separate accumulation account (they cannot go to increase the pension account holding the assets set aside solely to make pension payments).

Since the table below is an attempt to simplify things, there will always be exceptions to the rule, so do not regard this table as definitive. You need to check the position from current ATO material. And please read the notes below (or use the links) to understand the terminology used.

Age range Permitted contributions Permitted receipts
0 to 17 any none except employee's income stream
18 to <pa any none except employee's income stream
pa to 59 any A transition to retirement pension, that is an income stream (known as a TRIS) which cannot be commuted into a lump sum.
Upon retirement, a lump sum or income stream which can be commuted into a lump sum.
At this age, the taxable part of the income stream (or lump sum subject to a threshold) is taxable at a concessionary rate in the hands of the recipient.
60 to 64 any Under the transition to retirement (TTR) rules, a tax free income stream which cannot be commuted into a lump sum.
Upon retirement, a tax free lump sum or income stream which can be commuted into a lump sum.
65 to 69 Mandated employer contributions.
If work test is satisfied: non-mandated employer and member contributions.
Tax-free lump sum or income stream which can be commuted into a lump sum.
70 to 74 Mandated employer contributions (if applicable).
If work test is satisfied: non-mandated employer and personal member contributions.
75+ Mandated employer contributions only
(if applicable)

pa
means preservation age and is based on your date of birth as follows:-
before 1 July 1960 - 55
1 July 1960 to 30 June 1961 - 56
1 July 1961 to 30 June 1962 - 57
1 July 1962 to 30 June 1963 - 58
1 July 1963 to 30 June 1964 - 59
after 30 June 1964 - 60
So the third row in the above table will disappear in due course.

member contributions
contributions made by the member or by someone else (eg. a spouse) on behalf of the member

personal member contributions
member contributions made by the member (not made by someone else on behalf of the member)

mandated employer contributions (if applicable)
the super guarantee contributions (currently 9.5%* of notional earnings) which are made by an employer (or an associate of an employer) as required by law; also the definition includes payments made under an award

* This is planned to increase in staggered steps to 12% by 2022-23.

non-mandated employer contributions
made by an employer (or an associate of an employer) over and above their super guarantee or award obligations

the work test is satisfied
for the whole financial year if you have been gainfully employed (employed or self-employed for gain or reward in any business, trade, profession, vocation, calling, occupation or employment) for at least 10 hours a week, or at least 40 hours in a period of not more than 30 consecutive days in the financial year; looking at the combined effect of Regs 6.01(7), 7.01(3) and 1.03 the two possibilities appear to be alternative, which may be important if an employee is off sick or on leave during a relevant time.

an income stream
is effectively a regular pension payment: there is a minimum which can be paid from the fund each year. See types of benefit below, for the rules which apply. Also, under the TTR rules the income stream must be no more than 10% of the account balance in the superannuation fund each year.

retirement
occurs when the member has ceased work and the trustee is reasonably satisfied that the member intends never again to become gainfully employed, either on a full-time or a part-time basis. There is also automatic retirement for the purpose of these rules when a member aged 60 or over has ended his or her current gainful employment but if employment continues in another job special rules apply.

the taxable
part of the income stream or lump sum is assessed when the income stream is started or when the lump sum is paid, and it is that part of the fund referable to concessional contributions (employer contributions and member contributions for which an income tax deduction has been claimed).

Important!
Concessional and non-concessional contributions caps
(1) Annual caps

There are two types of contributions and each has an annual cap.

Employer contributions and member contributions for which an income tax deduction has been claimed are called concessional contributions. The fund must pay tax on receipt of these contributions. The rate of tax to be paid on these contributions is 15% or 30% on contributions in respect of members earning more than a certain annual amount. That annual amount is $300,000 in the tax year to 30 June 2016, or $250,000 in subsequent tax years.

In the year 1 July 2016 to 30 June 2017 the concessional contribution cap is $30,000, except that it is $35,000 for members of 49 and over on 30 June 2016. This cap will be $25,000 for the year 1 July 2017 to 30 June 2018. The caps apply to the total of employer and member contributions. Please check the current cap with the ATO because it is subject to change each year. Contributions in excess of the cap will be subject to tax at the member's marginal rate, but could optionally be retained in the fund as a non-concessional contribution.

If a member has past unused concessional cap amounts in the last 5 years (back to 1 July 2018) these will be able to be carried forward provided the total super fund balance for that member is less than $500,000.

Contributions for which an income tax deduction has not been claimed and which are therefore made out of savings or taxed income are called non-concessional contributions. The fund does not pay any tax on receipt of these contributions. A different and much higher cap applies to these and if the member is under age 65 it is possible to use up to three years' cap all at once under brought forward provisions. In the year 1 July 2016 to 30 June 2017 the annual cap is $180,000, or $540,000 using the brought forward provisions.

In the year 1 July 2017 to 30 June 2018 the annual cap is $100,000. The caps and rules are subject to change. Please check the current situation with the ATO. Contributions in excess of this cap which remain in the fund are taxed at 47%. However, there is now the option to remove the excess and restore the status quo by making a payment to reflect any tax benefit arising from having the excess in the fund for a while.

(2) Total super fund balance cap

From 1 July 2017 members with a total super fund balance of $1.6 million or more as at 30 June in the previous tax year, will be unable to make any more non-concessional contributions.

New transfer balance cap

From 1 July 2017 the total amount which can be transferred into retirement phase for a member is $1.6 million.

More definitions

Here are a few more to help you find your way around:-

While the fund is accumulating the assets and not making payments, it is said to be in the "accumulation phase". This is also referred to as the "growth phase". In the taxes acts, this is referred to as the "contributions phase" and the "investments phase".

Previously, once a fund started to make payments it was said to be in the "pension phase". In the amendments applied from 1 July 2017, this is now called the "retirement phase" and expressly excludes a transition to retirement pension. In practice a fund will be in retirement phase where it is paying a pension to a member who has retired or reached the age of 65 (or who has a terminal medical condition or is permanently incapacitated). In the taxes acts, this is also referred to as the "benefits phase".

If a retired member returns to work after the pension phase starts, and if the SMSF reverts back to the accumulation phase, this is called a "roll back".

Converting a pension or part of a pension into a lump sum is called a "commutation".

The pension regulations sometimes use the terms "benefits" to mean the member's account balance in the fund and sometimes to mean payments made to the member. This has the potential for confusion, so in my trust deed I have called the assets in the fund allocated to a particular member the "member's account balance". This closely follows those parts of the pension regulations which use the term "account balance". Some people use "member's accumulated benefit" or "member's account" to mean the same thing.

The following definitions are used in my trust deed to describe what happens to a member's account balance in different circumstances. These follow as closely as possible the use of these words and phrases in the superannuation legislation ("the SIS law"):-

"A member's account balance is:-
  1. cashed if it is paid by the Fund to the member or to another person in accordance with the SIS law: when this happens this is called a release or an early release;
  2. transferred if it is paid to another superannuation fund or to a Retirement Savings Account where the member has not yet satisfied a condition of release or early release under the SIS law; or
  3. rolled over if it is paid to another superannuation fund where the member has satisfied a condition of release or early release under the SIS law."
Co-contributions are where the government adds a percentage to a contribution made by a member. This might be where the member is a low earner and so is paying less than 15% tax. This is because contributions are taxed at 15% on receipt into the SMSF instead of at the member's marginal tax rate.

An SMSF is generally an "accumulation fund", that it to say it accumulates assets to be paid out on a certain event. It is not a "defined benefit fund" which is usually where the benefits follow a formula like a final salary scheme.

An "account based pension" is a pension or income stream paid out of a fund which has a members account balance.

Preserved and non-preserved benefits

All contributions made into the Fund since 1 July 1999 and also the income of the fund itself, result in a member's account balance containing what is described as preserved benefits. This means that the account balance must be preserved for the member until he reaches preservation age. But a superannuation fund which was in existence before 1 July 1999 may contain another category of money or assets. These are called non-preserved benefits.

Non-preserved benefits can be either restricted non-preserved benefits (RNPBs) or unrestricted non-preserved benefits (UNPBs). If you are starting a new SMSF and you rollover or transfer an existing superannuation fund into your new SMSF, then you may come across money or assets which need to be categorised in your accounts in this way. UNPBs can be released to the member at any time without condition. Employer's contributions made prior to 1 July 1999 will be RNPBs. On the cessation of employment with that contributing employer, the relevant RNPBs are converted to UNPBs. So from that date they can be released to the member at any time. Prior to the cessation of that employment, they cannot be released until a condition of release is satisfied in the same way as preserved benefits.

Other times when the fund can be released or cashed

Apart from the situations dealt with above, there are other times when the whole of the fund may be paid to the member or his estate. They are:-
  1. death;
  2. terminal medical condition;
  3. permanent incapacity;
  4. the permanent departure from Australia of former temporary resident who has established an Australian superannuation fund;
  5. being a lost member who is now found and the fund is less than $200.

And the following events will enable part of the fund to be paid out to a member

  1. if a payment is required or approved by the Commissioner of Taxation (ATO);
  2. severe financial hardship (the amount withdrawn may be subject to minimum and maximum limits, depending on the circumstances);
  3. compassionate grounds (the amount withdrawn will be subject to control by the ATO and depends on the circumstances);
  4. temporary incapacity (the money must be taken as an income stream to compensate for loss of earnings during the incapacity).

Internal taxation of the fund

The table below is a simplification of the rules which apply and assume:-
  1. all the fund's assets have been acquired on or after 21 September 1999
  2. each member has an account balance and that any pension paid to that member is paid from that account balance.

Type of receipt Accumulation phase
(also includes a fund paying a transition to retirement pension)
Retirement phase
(this does not include a fund paying a transition to retirement pension)
Non-concessional contributions No tax on receipt No tax on receipt
Concessional contributions 15% tax on receipt
(or 30% for high earners)
15% tax on receipt
(or 30% for high earners)
Income from investments 15% No tax on income from those assets held to provide for the income stream. This income is called exempt current pension income (ECPI).
Capital gains from investments 15% of gain upon disposal of the asset: if the asset has been held for 12 months there is a discount of one-third. Ignore any capital gain or loss arising from the disposal of assets held to provide for the income stream.

the assets held to provide for the income stream
is also known as the pension account balance or the pension account. These are the assets which are identified in the accounts of the fund as solely supporting the payment of the pension. They can be segregated in the fund if they are separately identifiable or they can be non-segregated and the proportion of the total assets of the fund that they represent can be certified by an actuary.

The procedures to be followed to identify these assets and the income derived from them are in the ATO document "Running a self-managed super fund", but are more precisely set out on the "tax professionals" area of the ATO site (search for "ECPI"). They include the need for a revaluation of all assets to their current market value before the pension payments start, and the need to follow proper accounting procedures.

Types of benefit payable during member's lifetime

Assuming that an event has occurred which allows a member to take benefits (as set out in the table above), then a superannuation fund may release benefits either as a lump sum or series of lump sums, or as a pension (income stream).

Lump sum or series of lump sums

On reaching 65 or on retirement, a member's account balance can be taken as a lump sum, and this can be done in one or more instalments if desired.

Pension (income stream)

As from 20 September 2007 only one type of pension can be paid by a superannuation fund and its rules are:-
  1. Except in limited circumstances the pension must be an account based pension that is, the assets held to provide for the income stream must be part or all of the member's account balance.
  2. The assets held to provide for the income stream cannot be added to by way of contribution or rollover after the pension has commenced.
  3. Pension payments must be made at least annually.
  4. A minimum amount must be paid each year being a proportion of that part of the member's account which holds the assets held to provide for the income stream. The proportion varies depending on age and is designed largely to use up the fund as time progresses. The minimum is 4% for 55-64 year olds and ranges to 14% at age 95 or older.
  5. The capital value of the pension and the income from it cannot be used as a security for a borrowing.
  6. The pension is transferable to another person only on the death of the member or death of the reversionary beneficiary, as the case may be.
  7. The pension cannot be commuted, in whole or in part, unless the commutation results from the death of the member or a reversionary beneficiary; or the member is entitled to take his account balance in cash (on reaching 65 or on retirement) or if the sole purpose of the commutation is:
    1. to pay a superannuation contributions surcharge; or
    2. to give effect to an entitlement of a non-member spouse under a payment split.
  8. The pension does not have to last any particular length of time, and can be stopped at any time. It can then be started again using changed level of segregated assets. If such changes are made the minimum annual pension payment will be calculated pro rata, and the fund's internal tax relief on income and capital gains in respect of the segregated assets will be interrupted.

Benefits payable after the member's death

After the death of a member of a superannuation fund, the member's account balance becomes available for distribution to others. Usually the member can specify in a Death Benefit Nomination what should happen to the account balance, and such a nomination can be made binding or non-binding on the trustee if the trust deed allows it. There may be tax consequences arising from such distributions and this should always be considered when making a nomination.

There are also some absolute restrictions under superannuation law as to how the account balance can be distributed, but assuming the trust deed allows it, the table below shows who can receive the member's account and in what form. This should be read whilst bearing in mind the definitions below the table.

Recipient Permitted benefit
deceased member's estate a lump sum
deceased member's spouse or de facto spouse lump sum or income stream or both
deceased member's child aged below 18 lump sum or income stream or both, but an income stream must cease at 25 unless the child has a permanent disability
deceased member's financially dependent or permanently disabled child aged 18-25 lump sum or income stream or both, but an income stream must cease at 25 unless the child has a permanent disability
person with whom deceased had an interdependency relationship lump sum or income stream or both
any person who was reliant on the deceased for financial maintenance at the time of death lump sum or income stream or both
any other person lump sum only

spouse or de facto spouse can include same sex couples.

child includes an adopted child, a stepchild, an ex-nuptial child of the person, and a child of a spouse and a child as a result of artificial insemination or surrogacy agreement.

An interdependency relationship exists between two people where they have a close personal relationship, and they live together, even if they are not related by family, and one or each of them provides the other with financial suppoer and also domestic support and personal care. If one person provides another with domestic support and personal care but does not satisfy any of the other tests because of physical, intellectual or psychiatric disability, this will suffice.

a person who relied on the deceased for financial maintenance

Although this category of person does not appear in the superannuation law which defines a "dependant", the ATO accept it as a separate category because there is no exhaustive definition of dependant in the legislation. So it is said that a person who relied on the deceased for financial maintenance is also a "dependant". This liberal interpretation may at some point open to challenge but it is a generally accepted view.
Note also that in the case of the death of a member prior to 1 July 2017, in certain circumstances a lump sum payment made to a spouse, a former spouse or to a child (including an adult child) of the deceased member can be increased to compensate for the contribution tax that had been paid on the member's contributions. This is called an "anti-detriment payment".

Jeremy Gordon
26 November 2016

Copyright © Jeremy Gordon

DirectDocs® is a registered trade mark in Australia

This article only applies to Australian superannuation schemes regulated by the Australian Tax Office, which pay benefits based on the amount of the members' account balances in the scheme.

Disclaimer
This article does not arise from any instructions from you and it is not legal advice given to you. You should check for yourself how Australian pension schemes work. If you follow the information on this page, you do so at your own risk.

Sources:
(the link opens in new window)
The best source is the ATO site where you can search for the online documents:
"Running a self-managed SMSF Fund"
"Thinking about self-managed super"
"Key superannuation rates and thresholds"
These documents are usually very clear and up to date. If you are managing everything yourself I would recommend that you also read articles on the ATO site for tax professionals. These pages are equally as clear as those intended for the non-professionals, but all possible permutations and scenarios are covered. Bearing in mind that members of an SMSF have ultimate responsibility as trustees for the fund (even if they employ advisors or administrators) this will give you peace of mind. Always check the date to which a document has been updated and double check its provisions if in doubt.

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Jeremy Gordon is an Australian barrister. He can be contacted by email using
or by mail at PO Box 354 Corinda QLD 4075.
The conditions applying to his work are here (opens in new window).