Australian superannuation - how it works

Introduction

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

If you are thinking of establishing an 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 of the Australian superannuation regime is straightforward: during your working life you can put sums and assets in a superannuation fund, subject to caps. If you are employed, your employer is obliged to make superannuation fund payments for you (you do not pay personal tax on this money). You can also make your own contributions and up to an annual cap you may deduct these from your income and therefore reduce your personal tax bill.

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 between "preservation age" and your 65th birthday and still working you can take a "transition to retirement" pension with a minimum and maximum annual withdrawal, but if retired or aged 65 or over you can withdraw as much as you like as a lump sum or take a pension with a minimum annual withdrawal or you can take both. 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 usually not pay tax on the income from the assets set aside to enable those payments to be made.

There will be a time in which in your personal circumstances, you can take a pension from your superannuation fund but at the same time make contributions to the fund. This is perfectly legitimate but the contributions must go into an accumulation account (they must not be added to the account from which your pension is being paid). The accumulation account can be used later to start a new pension, or added to your existing pension account, provided your total amount in retirement phase does not exceed the transfer balance cap.

The Self-managed Superannuation Fund

An SMSF is a superannuation fund which you yourself can manage directly, and act as its trustee. 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.

You may prefer to engage a professional to do some or part of the work. In Australia there is quite an industry in offering SMSF services - lawyers, accountants, financial planners, investment advisers, and SMSF administrators. But such professionals do not become trustees of the SMSF, nor take over the trustees' responsibilities - the responsibility will always remain with you.

The pension scheme in more detail

There are five tables below which help to explain how things work and you can follow the definitions of the words and phrases used in the table. Please note that there will always be exceptions to the rule, and changes, so do not regard the information here as definitive. You need to check the position from current ATO material.

You can start with the age table. This is because it is the age of the member of the superannuation fund which largely determines how the fund must operate with respect to that member, and what contributions and receipts are permitted.

Then move on to the contributions table. This explains how each type of contribution is dealt with for tax, and the caps which apply.

Then there is the pensions table. This shows how each type of pension is dealt with for tax, and the rules which apply to them.

There is also the internal taxation table and a table showing the benefits payable on death of the member.

Exceptional Circumstances

In exceptional circumstances a condition of release will be satisfied. 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).

First Home Super Saver Scheme

A member's voluntary contributions can be released to help towards the purchase of a first home. Certain conditions apply which are likely to change. For up to date information see the ATO's website.

Employee's Life Pension

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 non-commutable life pension or annuity and not by way of lump sum (unless the lump sum would be less than $200).
[This may be regarded as an anomaly but it is permitted by item 108 in Schedule 1 of the Supervision Industry (Supervision) Regulations 1994. It seems to be discouraged by employer's superannuation schemes but it could be permitted by your SMSF if it received employer contributions].

Preservation Age

Prior to 1 July 2024, this was the age when a member could start to withdraw from a superannuation fund. The preservation age was based on the 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

As from 1 July 2024 there can be no preservation age earlier than age 60.

Transition To Retirement (TTR) pension

This is also known as a transition to retirement income stream (TRIS). It can be started whilst still working and between preservation age and your 65th birthday. See below for the rules applying to such pensions.

Retirement

This happens 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.

Assumed retirement

There is automatically assumed retirement when an arrangement under which a member aged 60 or over was gainfully employed comes to an end. This may seem to be an anomaly, but it is provided by Reg 6.01(7)(b) of the Superannuation Industry (Supervision) Regulations 1994.

Retirement Phase pension

A pension paid from sums and assets in an account which is in retirement phase. See below for the rules applying to such pensions.

Taxable receipts when under 60

From 1 July 2024 this can only apply in exceptional circumstances and it is possible that part of an income stream or lump sum will be assessable for tax. For up to date information see the ATO's website.

Mandated Employer Contributions

These are the contributions to your super which an employer must make (the super guarantee contributions). The rate is currently 11½%* of notional earnings. See here how these contributions are dealt with for tax.

*	This will increase to 12% on 1 July 2025.

Non-mandated Employer Contributions

They are contributions made by an employer (or an associate of an employer) over and above their super guarantee or award obligations. This will usually be in accordance with an award or a contract of employment. See here how these contributions are dealt with for tax.

Member Contributions

Member contributions are contributions not made by an employer of the member. They could be contributions by salary sacrifice if they go through payroll for an employee, or simply a lump sum paid into the fund by the member unrelated to any income or earnings of the member. Member contributions can be "concessional" where the member claims a deduction from income tax, or "non-concessional" where no such claim is made. See here how member contributions are dealt with for tax.

Also a person may claim a limited tax offset after making a contribution on behalf of a spouse with limited income under the age 75.

Downsizer Contributions

Members aged 55* and above can contribute to their super up to $300,000 from the proceeds of the one-off sale of their main residence.

*	The downsizer contributions have been available from 1 July 2018 (for those aged 65 and above), from 1 July 2022 for those aged 60 and above and from 1 January 2023 for those aged 55 and above.

The Work Test

The work test is satisfied for the whole financial year if the member has been gainfully employed (employed or self-employed for gain or reward in any business, trade, profession, vocation, calling, occupation or employment) for at least 40 hours over 30 consecutive days in the financial year.

Carry forward unused concessional cap amounts

A member who has not used up their full concessional cap is able carry forward the unused amount, provided the member's total super fund balance is less than $500,000.

From 1 July 2024 the carried forward is limited to five years, so that any unused concessional contributions can only be used (if eligible) up to five years later.

Bring forward rule

It is possible to use up to three years' cap all at once in a financial year under the bring forward provisions unless the member has a total superannuation balance close to the transfer balance cap of $1.9m. If the bring forward rule is triggered, then the member is restricted in the contributions that can be made in the next two years.

The bring forward rule can be used by members aged up to 75 and within a few days after (a fund can accept such contributions if received on or before the day that is 28 days after the end of the month in which the member turns 75). After that age it cannot be used.

Total superannuation balance

This is the total balance in accumulation and retirement (pension) accounts across all Australian superannuation funds.

*	Where the pension commences mid-financial year, the minimum payment is reduced proportionately.

†	These minima were halved for the years 2019-20, 2020-21, 2021-22 and 2022-23 but then reverted to the usual amounts.

Pension or retirement account

When a fund is paying a pension (income stream) this is the account which holds the sums and assets in the fund set aside to pay that pension. In the case of a transition to retirement pension it is known as the pension account. If a fund is paying a superannuation income stream, that is a pension where the income and capital gains of the sums and assets set aside to pay the pension are not chargeable to tax because the fund is in retirement phase, then it is known as a retirement account.

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.

Accumulation Phase

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". Any sums and assets which are accumulating in this way are said to be in the accumulation account. This is why an SMSF is known as 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.

Retirement Phase

A fund which legitimately starts paying a superannuation income stream is said to be in "retirement phase". A superannuation income stream is a pension where the income and capital gains of the sums and assets set aside to pay the pension are not chargeable to tax. 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) and there is no more than the transfer balance cap in the retirement phase account. A fund which is paying a transition to retirement pension will not be in retirement phase.

It is possible for a fund to be both in an accumulation phase (with an accumulation account) and paying a transition to retirement pension or in retirement phase at the same time. This is because the fund may receive contributions despite paying a pension. Such contributions must however, be paid in the accumulation account.

Sums and Assets Set Aside to pay the pension

These are the assets which are identified in the accounts of the fund as solely supporting the payment of the pension. In the case of a transition to retirement pension it is also known as the pension account balance. In the case of a superannuation income stream it is known as the retirement account balance. The accounts holding these balances can be segregated from other accounts 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.

Some other definitions

If a retired member returns to work after the retirement 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.

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

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."

Contribution splitting is where a member splits a contribution between the member's superannuation account and to someone else's superannuation account (eg. a spouse) but claims a deduction from income for the whole contribution.

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. To be eligible you must have a total superannuation balance less than the general transfer balance cap and must not have contributed more than your non-concessional contributions cap.

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.

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 age table), 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. The amounts can be seen from the pensions table.
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.

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
1 August 2024

Copyright © Jeremy Gordon