SUPERANNUATION TAX CONCESSIONS ENCOURAGE GROWTH IN RETIREMENT SAVINGS

Since the first self managed superannuation funds (SMSFs) were established, this sector of the financial services industry has seen steady growth year after year. The latest Australian Taxation Office (ATO) figures show that there are now over 600,000 SMSFs managing the retirement savings of more than 1.1 million Australians.

There are several benefits to establishing an SMSF, including the amount of control the trustees have over their investments when compared to industry and retail superannuation funds. However, the major benefit is the generous tax concessions that compliant SMSFs can access.

For example, SMSFs that comply with the superannuation legislation have their member contributions and fund earnings taxed at the concessional rate of 15% in Australia. This is called the accumulation phase. Once you are over 60 years of age you can access your superannuation tax free, but if you move your super into retirement phase to get a pension rather than taking it as a lump sum, the earnings on the investments supporting your income stream are also tax-free.

Of course, there are rules and conditions attached to achieving this tax-free status for eligible SMSF members, and not understanding or complying with these rules and conditions could see you jeopardise this key benefit. The tax exemption on earnings in retirement phase is called exempt current pension income (ECPI), and you must claim it correctly or miss out.

ECPI is claimed in your SMSF’s annual return when your fund starts paying one or more retirement phase income streams. There are two methods that can be used, the segregated method and the proportionate method. Where the SMSF’s assets supporting retirement income streams are clearly held separate from any other assets, the segregated method should be used.

The proportionate method is used where the SMSF does not set aside specific assets to support retirement income streams and it is the one most commonly used by SMSFs. This method applies when the fund has a member or members in both the accumulation and the retirement phase, and the assets have not been segregated but are all pooled in together.

An actuarial certificate is required from an actuary who calculates the exempt proportion and applies it to income earned in that period, which forms part of the fund’s total ECPI for the year. This is a complex area that can easily confuse fund trustees who are more conversant with investment strategies than they are with actuarial calculations.

Many trustees engage companies such as SMSF Assure to help them navigate the complex administration and reporting requirements of running an SMSF. There are several more issues involved in calculating a fund’s ECPI other than those already mentioned. Getting additional professional expertise for these calculations is preferable to making a mistake and suffering a financial penalty.

The lure of a tax-free status in retirement has been a large part of the growth of SMSFs. Successive federal governments have encouraged this growth so that working Australians can provide for their own retirement rather than rely on the government-funded Aged Pension. Superannuation is one of the best vehicles Australians have to reduce their tax payments while creating wealth for their retirement.

DO ANY OF THESE ATO CONCERNS APPLY TO YOUR SMSF?

Each year there are changes to the rules that govern superannuation and self-managed superannuation funds (SMSF), and for some fund trustees it can become difficult to remain compliant with ATO (Australian Taxation Office) laws.

Currently, there are three key issues that are causing the ATO some concern. If you are a trustee who has let some of the standard processes slip a little, a good place to start would be to understand these issues and check that your fund operations have not unwittingly become illegal.

The Sole-Purpose Test

The first issue is fundamental to SMSF and super regulation, and a key part of investment decision-making. It is the sole-purpose test, which means that to be eligible for tax concessions, an SMSF must be maintained for the sole purpose of providing retirement benefits to its members. While this seems simple enough, it is often misunderstood by fund trustees.

For example, recently the Federal Court dismissed an application by a fund trustee who was challenging the commissioner’s view that funds to provide accommodation for a member or relative was in breach of this rule. The Court agreed with the commissioner that leasing to a related party was contravening the sole-purpose test by using the fund assets for a purpose other than providing retirement benefits. This court decision has reinforced the sole-purpose test.

In-house Asset Rules

An in-house asset is a loan to, or investment in, a related party, an investment in a related trust, or an asset of the fund that is leased to a related party. A fund’s in-house assets cannot exceed 5% of its total assets, but unfortunately, a common regulatory breach being seen by the ATO regarding SMSFs is that funds are lending fund monies or assets to members or relatives of members of the fund.

Before going down this path, fund trustees are invited to contact the ATO for clarification or seek independent professional advice.

Unlawful Schemes and Arrangements

SMSFs have become prime targets for approaches by the unscrupulous to become involved in unlawful schemes and arrangements that may seem quite legitimate at the time.

ATO officers advise that these illegal arrangements are complex and cleverly hidden and can result in severe consequences for trustees and their funds. One such arrangement is to roll future retirement savings out of a superannuation fund and into an SMSF so that it can be withdrawn and used for a housing deposit.

This is illegal and the ATO is concerned that SMSF fund members are being targeted with these and similar arrangements that could result in fund members losing their life savings. The ATO is always available to assist trustees, and there are reputable professional advisors available to trustees who have been approached with a scheme and are confused about what to do.

There are also many reputable companies such as SMSF Assure working in the industry that are not licensed to provide financial product advice but are experts in fund administration. By having their assistance with the compliance and reporting part of your SMSF, fund trustees can then turn their full attention to the financial products and investment opportunities in the market, without falling prey to market predators.

ASK THE RIGHT QUESTIONS BEFORE STARTING YOUR SMSF

Self-managed superannuation funds (SMSFs) continue to attract interest from potential fund trustees eager to make the leap into taking control of their own retirement income. The problem that many of them face is in knowing what questions to ask and where to go to find the answers. To get them started, the most important information they need to know is how to go about setting it up.

At the start, many people assume that there is only one way to structure their fund, so when they find out differently, the first question they ask is about the differences between two options. They then find that the first option is to have individual trustees and the other is to establish a company acting as trustee for the fund. Both of these options should be discussed with a professional before making any decision, as they are difficult to change later.

The next question to be asked, naturally enough, is usually about costs. They find that there are no Australian Securities and Investments Commission (ASIC) fees for a fund with individual trustees, resulting in reduced establishments costs and lower ongoing administrative requirements. However, ASIC charges a fee for the initial registration of a corporate trustee, followed by annual review fees. In the case of both structures, trustees or directors cannot be paid fees for their duties or services relative to the fund.

The ownership of the fund assets is often the next question asked. For an SMSF with individual trustees, the title of the fund assets must be in the name of the current trustees, “as trustees” for the fund. If the trustees change, then the titles must also be changed, which can be expensive. In the case of a corporate trustee, when a person leaves the fund, they cease to be a director and although ASIC must be notified of the change of directors, the titles of the assets remain unchanged.

Often, potential trustees already hold personal assets that are not intended to be part of the fund. They want to know before going any further what will happen to those assets. The answer to this question is quite simple. The assets of the fund must be kept completely separate from any personal assets held by the trustees. The fund assets must be in the name of the fund. Corporate assets are exactly the same except that companies have limited liability.

Finally, the question of penalties for non-compliance arises. Trustees must always be mindful that if superannuation laws are breached, each trustee is liable individually for the administrative penalties. If the same penalties were to be levied on a corporate trustee, they would only be applied once.

There are many other questions to be asked and answered in much more detail than is possible here. Suffice to say that there are companies such as SMSF Assure that will assist trustees with all the administrative details involved in running an SMSF, so they are in a perfect position to give complete and comprehensive answers to these questions.

ORGANISING YOUR SUPER FUND – THE KEY STEPS

If you have a good understanding of the mechanics of superannuation and a flair for spotting a good investment, you may be thinking about establishing your own SMSF. The initial organisation is not particularly difficult, especially as all the steps required are set out clearly by the ATO (Australian Taxation Office).

However, getting it right is important because only a compliant fund is eligible for tax concessions and it can receive contributions. You could engage SMSF professionals to help you set up the fund but if you prefer to organise the fund yourself, there are important things you must do.

The first thing you must do is choose between having individual trustees or a corporate trustee, each of which differs in terms of the member and trustee requirement, costs, ownership and separation of the fund assets, penalties and succession. These are all critical decisions, which, once made, are very difficult to change.

Next is to choose your eligible trustees or directors, depending on which fund structure you choose. All trustees and directors must consent in writing to their appointment and sign the Trustee declaration. You must keep these documents secure for the life of the SMSF and for ten years after it is wound up.

Now you must create a trust deed; this is the legal document that establishes the rules by which the trust is managed. This must be prepared by someone with the relevant legal qualifications. There must also be a nominal initial contribution of assets to give legal effect to the fund.

Within 60 days of signing the trustee declaration, you must register the SMSF with the ATO by applying for an ABN (Australian Business Number). Now you can open a bank account in the fund’s name. This account will be used to manage the fund operations.

You may also need an electronic service address, which is a special internet address that is different to an email address. Finally, even at the start of this venture, you will also need an exit strategy. Such a strategy reduces the effects of an unexpected event such as a death, a relationship breakdown between the trustees or some other occurrence.

If you still want to go ahead with the SMSF but daunted by the prospect of the day-to-detail now that you have a taste of what is involved, all that is needed is to enlist the assistance of companies such as SMSF Assure to do the administration, while you divert your energies to building a retirement nest egg.

Now think carefully before you decide to go it alone. Many important decisions are needed that can be provided by a range of professions covering accounting, administration, legal, financial and tax advice. Not using their expertise could have a huge impact over your final retirement balance.

SMSF RISKS YOU MAY NOT KNOW ABOUT

As trustee of your SMSF (self-managed superannuation fund), you would be aware of the responsibility you have to manage investments that will produce a comfortable income in retirement. You may have outsourced the fund administration to professionals such as SMSF Assure and engaged a licensed financial advisor to assist with investment decisions, but ultimately, the final responsibility for the fund performance is yours.

Apart from the usual market forces that affect any type of investment you make, there are some other, lesser known risks of which we should be aware. Three risks in particular are not directly linked to any investment category, which is most likely why they are often overlooked by SMSF trustees.

Risk No. 1 – Sequencing

The first is known as a sequencing risk and needs some explanation. You already know that investments perform better in some years than in others, but you may not have realised that the sequence in which these changes occur are just as important as the actual investment returns.

This particular risk came to prominence during the GFC (global financial crisis) when people close to retirement lost heavily as their share portfolios crashed. Those affected retired with less than they expected had the GFC not occurred, or in some cases, stayed in employment for much longer to recoup as much of their losses as possible.

Sequencing is all about timing. Losses made in the early stages of your working life can be recouped over time so that the fund balance is healthy at retirement. Those same losses later in life will likely have a profound negative impact on the balance available as members retire.

There is no single way to manage this sequencing risk. However, ensuring that the fund assets are diversified across several investment classes spreads that risk and lessens the overall long-term affect. Changing the asset mix over time to reduce volatility and having enough liquidity to avoid selling assets will maintain capital and keep the fund healthy.

Risk No. 2 – Liquidity

Liquidity then, or lack of it, is the next risk. A healthy SMSF needs cash on hand throughout its existence. Cash is required for administration, auditing, investment fees and other expenses. Fund members in the pension stage will need cash for pension payments or, in the case of bereavement cash to pay the family a benefit. Having cash in a high interest cash account is the best way to manage this risk.

Risk No. 3 – Underinsurance

Having the fund underinsured is the third major risk. Superannuation rules require fund trustees to consider insurance cover for its members, but some SMSFs choose not to do so. This places the fund at risk if assets must be sold, whatever the market conditions, in the event of the death or total and permanent disability of a fund member.

If members are insured against these or similar events, this insurance will most likely cover much of these expenses, leaving the fund assets intact and working to keep the fund balance healthy. These additional risks should be discussed with your financial advisor and plans put in place to manage them.